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 If you've ever traded stocks, then it's only natural to wonder what commodity trading is all about. Here we're going to give you a little introduction to the commodities market - just enough to whet your appetite. We'll run through the background of the market and the types of contracts you can buy. Later in this series we'll and talk about futures contracts in more detail and some of the hedging strategies used by those trading commodities.
History of the Commodity Market
In the early 1840s, Chicago's infrastructure of rail and waterways made it a logical place for the mid-west farmers to meet with the dealers that were willing to ship their harvests to markets around the country. Making deals became a natural for farmers looking for a sure place to sell their crops and dealers that needed a reliable source of grain.
At first a "spot" market evolved as farmers looking to find a buyer, brought their grain to the Chicago market in the hopes of selling it "on the spot" for cash. While this helped the farmer sell his product, the overall process was less efficient than it could have been.
The first "futures contracts" were likely handshakes between dealers and farmers - an agreement that outlined the purchase price and quantity of the grain delivered by the farmer at a future date in time. Soon these contracts were written agreements and speculators began trading in these futures contracts - hoping the laws of supply and demand would work in their favor.
By 1848, the Chicago Board of Trade (CBOT) was founded by 82 Chicago merchants, and they settled into their first home above the Gage and Haines flour store at 101 S. Water Street where it stayed until 1852. There was now an organization that could help farmers find buyers and provide for a more robust trading marketplace.
The Trading of Commodities
The commodities trading in Chicago market originally started out as a way to trade in agricultural products. Today the CBOT supports the trading of four product types - agricultural, metals, interest rates, and the Dow. In general, to create an attractive trading market for a commodity, its future price must be somewhat uncertain. It is this uncertainty that creates an opportunity for profit, thereby increasing investor interest.
Agricultural Commodities
Agricultural commodities include items such as corn, soybeans (meal and oil), ethanol, oats, wheat, and rice. Trading in these products is standardized as to quantities and product condition. For example, agricultural products are traded in a raw / unprocessed state.
Metal Commodities
The most common metal commodities are gold and silver - the price of which is stated in dollars per ounce. The most familiar trading quantities on the CBOT include:
- 100 ounce Gold Futures
- Mini-sized Gold - 33.2 fine troy ounces of gold
- 5,000 ounce Silver Futures
- Mini-sized Silver - 1,000 troy ounces of silver
Dow Futures
Dow futures include the Dow Jones AIG Commodity index, the Dow Jones Industrial Average Futures and the mini-sized Dow. The strategy of trading in Dow futures is also called "trading the markets." With Dow futures, you are attempting to predict the future direction of the stock market and the Dow in particular.
Interest Rates
Finally, the last product type offered by the CBOT falls into the category of interest rates. The most common of the interest rate trades includes treasury bonds, fed funds, and municipal bonds. When trading in the interest rate market, you are attempting to capitalize on the long and short term changes in the yield curve. Said another way, you're taking a financial position that interest rates are going to rise or fall in the future.
Other Commodities
There are many other commodities that can be traded from tin to coffee beans or stock indexes to pork bellies. As long as there is uncertainty around the future price of these items, there will be an interest in trading. And as long as price movement exists, investor interest exists.
Commodity Exchange
In today's world of specialization, we see that domestic and international commodity exchanges have also grabbed on to the concept of focusing in on an area of expertise. The most robust commodity exchanges in the world today and their specialty commodities include:
- New York Board of Trade (NYBOT) - which includes coffee, cocoa, cotton, orange juice, and sugar.
- New York Mercantile Exchange (NYMEX) - which specializes in energy products such as crude and heating oil, gasoline, natural gas, coal, propane as well as metal such as gold, silver, platinum, copper, aluminum, and palladium.
- Chicago Board of Trade (CBOT) - which specializes in bonds and more traditional commodities such as corn / maize, oats, rough rice, soybeans, soybean meal, soybean oil, and wheat.
- Chicago Mercantile Exchange (CME) - which specializes in bond futures and more traditional commodities such as live and feeder cattle, lumber, beef, boneless beef trimmings, lean hogs, frozen pork bellies, fresh pork bellies, milk, and butter.
- London Metal Exchange (LME) - which specializes in the trading of metals such as copper, lead, zinc, aluminum, tin, and nickel.
- London Commodity Exchange / Euronext - which specializes in the trading of commodities such as grains and meat.
- ICE Futures - the International Petroleum Exchange specializes in commodities such as crude and heating oil, natural gas, and unleaded gasoline
Commodity Trading and Futures Contracts
As mentioned earlier, most investors interested in commodity trading participate in this market using futures contracts. A futures contract is simply a standardized contract to buy or sell something (a commodity in this instance) at a future date and at a pre-established price. The pre-established price is called the futures price and the date is called the settlement date.
Commodity Trading Strategies
Because of the money involved and because much of the trading is done on margin, the strategy adopted by most traders falls into one of the following two strategies:
- Speculators - investors that attempt to seek profits by attempting to predict where the commodity market is going and are only interested in buying the commodity on paper.
- Hedgers - these are investors that have a reason for possibly taking possession of the commodity itself and are looking to protect themselves from price movements by adopting a hedging strategy.
Commodity hedgers typically include the producers and /or the consumers of the underlying commodity. For example a farmer might sell a futures contract to lock in a price on their crop. Hedging makes it much easier for them to plan their growing expenses around their expected revenues.
Commodity Strategies and Risk
Finally, the real purpose the commodities futures - or any futures contract for that matter - is to facilitate the transfer of risk from one entity to another. On either side of any deal you've got two parties each with a different outlook on the future. Each participant is willing to take on the risk of price increases or declines over time.
That's what makes commodity trading so intriguing for many individuals - the mere fact you can find someone that perhaps thinks very differently than they do and are willing to possibly take a position in a commodity that opposes their own. And for traders or speculators that like the rush of a good competition, you can't get much more competitive than trading in commodities.
Next up in this series is an Intro to Future Contracts.
About the Author - Intro to Commodity Trading
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