CTS Lesson 1: What Are Commodities?

What Are Commodities?

By: Carley Garner

Commodities are any interchangeable product and consequently share a common price. For

example, bulk goods such as grains, metals, livestock, oil, and cotton. Financial products such as

bonds, currencies and stock market indices are also considered commodities.

Commodity transactions generally take place in two related markets: the cash market and the

futures market. Prices are determined in each of these markets by the motives of buyers and

sellers. Obviously each side is looking out for their personal interest. Buyers are looking for the

lowest possible price, while sellers are attempting to get the highest possible price. Depending on

the situation, buyers may have more motivation behind their bids pushing prices up. Conversely, if

buyers are scarce and sellers are more motivated to execute a transaction, prices are pushed lower.

Cash Market

The cash market can be either a spot or forward market. In a spot market, there is immediate

physical delivery of a specified commodity. A forward contract specifies a specific commodity to be

delivered at a specific date in the future. While a forward contract is similar to that of a futures

contract, there are some important differences. A futures contract is standardized as to the size and

delivery date. A forward contract is negotiated between the buyer and the seller as to the size and

delivery date. Together the forward and spot markets are known as the “actuals,” since the actual

physical delivery must be made.

The Futures Market

The first futures market, the Chicago Board of Trade, was established in Chicago during the 1860’s.

It was originally founded as a cash market, and began trading futures contracts after inception.

Since the beginning of the CBOT, several other exchanges have popped up throughout the world.

A futures contract is simply a special type of forward contract. They are standardized binding

contracts designed to reduce risk and increase flexibility of forward contracts. In a futures market, an

agreement is made to buy or sell a specific quantity and grade of a particular commodity during a

designated delivery period. The contract also specifies delivery points and price variations for

discrepancies in quality or grade. If the contract were held until delivery date, the parties involved

would be obligated to make or take delivery. Those with open contracts beyond the first notice day

do run the risk of being assigned a cash position by the exchange even if the delivery date has not

yet arrived. Most commodity traders are speculators and do not intend to take or make delivery. In

fact, over 97% of futures contracts are not delivered.

The standardization of futures contracts makes it possible for traders to easily transfer positions. At

any time before expiration, a contract can be bought or sold with ease. With so many buyers and

sellers competing freely, the futures market offers a very efficient means of determining commodity

prices with enough liquidity to provide investors a forum to trade with low transaction costs. As a

result of the efficiency seen in the futures market, futures prices are considered to be an accurate

reflection of the cash market.

Hedging

Perhaps the most important function of the futures market is its ability to transfer risk from

commodity users and producers to those willing to accept that risk in hopes of high returns. In other

words, commercial users of bulk goods can hedge their cash position by entering an equal and

opposite transaction in the futures market. In a sense, they are insuring future cash transactions.

Doing so will reduce the risk of financial loss due to market fluctuations in commodity prices. As a

result, producers actually minimize their cost of doing business and ultimately provide consumers

with lower priced goods.

Speculators

Speculators play a very important role in futures markets. They provide an immediate source of

liquidity to the markets. Without liquidity, commodities would not be fairly priced in the futures

markets, transaction costs would be highly inflated and the days of buying and selling futures

contracts with ease would be non-existent.

A speculator is just that, a trader with the goal of profiting on future price moves. If the market

appears to be overpriced, speculators sell contracts hoping that prices will come back down to

reasonable levels. Similarly, if prices are low they will buy looking for a rally in the market. Because

of large contract sizes, individual traders tend to execute smaller positions than hedgers and hold

those positions for a shorter period of time. Therefore, it is necessary for the market to have several

speculators participating in the market in order to take the opposite side of a hedged position.

Commodity

transactions

generally take place

in two

related markets:

The cash market and

the futures market.

Futures Traders Helping Future Traders