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