Commodity Trading: What is it all about?

Commodity Trading: What is it all about?

A commodity market is a market that trades in primary economic sector instead of industrial products. Soft commodities are agricultural products such as wheat, coffee, cocoa, fruit and sugar. Hard commodities are mined, such as gold and oil.

Commodity trading word blue color.

Investors access about 50 major commodity markets worldwide with purely financial transactions increasingly outnumbering physical trades. Futures contracts are the oldest way of investing in commodities.

History of Commodity

Futures are secured by physical assets. Commodity markets can include physical trading and derivatives trading using spot prices, forwards, futures, and options on futures. Farmers have used a simple form of derivative trading in the commodity market for centuries for price risk management.

Dealing commodities is an old profession, going back to more than trading stocks and bonds. Earliest civilizations traded a broad array of commodities, from seashells to spices. Commodity trading was an fundamental business.

The might of empires can be seen as slightly proportionate to their ability to create and manage complex trading systems and ease commodity exchange, serving as the wheels of commerce, economic development and taxation for a kingdom’s treasuries.

Although majority of the principals were individuals who actually made or utilized the physical products in some way, there were probably investors eager to bet a drachma or two on the approaching wheat harvest, for example.

Investment word with color red.

Where to Invest Commodities

There are still a lot of commodities exchanges around the world, although numerous have merged or left out of business over the years. Most carry a few different commodities, although some specialize in a single group. For example, the London Metal Exchange only carries metal commodities, as its name suggests. Commodity trading in the exchanges can require standard contracts so that trades can be surely implemented with no visual review.

Investment Characteristic of Commodities

Basic economic fundamental of supply and demand usually drive the commodities markets: lower supply drives up demand, which equals higher prices, and vice versa. Major disturbances in supply, such as a widespread health scare among cattle, may lead to a spike in the generally stable and foreseeable demand for livestock.

On the demand side, worldwide financial growth and technological advances often have a less dramatic, but significant result on prices. Case in point: The emergence of China and India as important industrial players has contributed to the declining availability of industrial metals, such as steel, for the rest of the world.

Commodity Price Index

A commodity price index is a fixed-weight index or (weighted) average of selected commodity prices, which might be founded on spot or futures prices. It is intended to be representative of the wide commodity asset class or a particular subset of commodities, such as energy or metals. It is an index that tracks a basket of commodities to measure their performance.

These indexes are regularly traded on exchanges, enabling investors to gain easier access to commodities with no having to enter the futures market. The value of these indexes fluctuates based on their underlying commodities, and this price can be traded on an exchange in much the same way as stock index futures.

Investors can choose to get a passive exposure to these commodity price indices through an overall return swap or a commodity index fund. The benefits of a passive commodity index exposure include negative connection with other asset classes such as equities and bonds, as well as protection against inflation.

The disadvantages include a negative roll output because of contango in certain commodities, though this can be reduced by active management techniques, such as decreasing the weights of certain constituents (e.g. precious and base metals) in the index.

Commodity futures word with dollar background.

Commodity Index Fund

A commodity index fund is a fund whose assets are invested in financial instruments based on or connected to a commodity index. In just about each case the index is in fact a Commodity Futures Index. The first such index was the Commodity Research Bureau (CRB) Index, which started in 1958.

Its construct made it unusual as an investment index. The first essentially investable commodity futures index was the Goldman Sachs Commodity Index, made in 1991 and known as the “GSCI”. The next was the Dow Jones AIG Commodity Index.

It varied from the GSCI primarily in the weights allotted to each commodity. The DJ AIG had components to periodically limit the weight of any one commodity and to remove commodities whose weights became too small. After AIG’s financial problems in 2008 the Index rights were sold to UBS and it is now known as the DJUBS index. Other commodity indices include the Reuters / CRB index (which is the old CRB Index as re-structured in 2005) and the Rogers Index.

Cash Commodity

A cash commodity is a palpable product to be brought in exchange for payment and is viewed most often with futures options. An agreement for a cash commodity will identify the accurate quantity of the commodity which is predictable to be delivered, along with the delivery date, and the price.

Call option spelled out with white tiles on black background.

Call Options

In a call option counterparties go into a financial agreement option where the purchaser purchases the accurate but not the obligation to purchase an agreed amount of a specific commodity or financial tool from the seller of the option at an assured time for a certain price. The seller is obligated to sell the commodity or financial tool should the purchaser so choose. The purchaser pays a fee for this right.

Derivatives

Derivatives developed from simple commodity future contracts into a varied group of financial instruments that apply to all kind of asset, including mortgages, insurance and many more. Futures contracts, Swaps (1970s-), Exchange-traded Commodities (ETC) (2003), forward contracts, etc. are examples. They can be traded through formal exchanges or through Over-the-counter (OTC). Commodity market derivatives unlike credit default derivatives, for example, are protected by the physical assets or commodities.

Commodity Exchange concept on the gearwheels.

Commodities Exchange

A commodities exchange is an exchange where various commodities and derivatives are traded. Most commodity markets across the world trade in agricultural products and other raw materials and contracts based on them. These contracts can include spot prices, forwards, futures and options on futures. Other sophisticated products may include interest rates, environmental instruments, swaps, or freight contracts.

Top Commodities Exchange

1. Chicago Mercantile Exchange (CME)

2. Chicago Board of Trade (CBOT)

3. New York Mercantile Exchange (NYMEX)

4. London Metal Exchange (LME)

5. Intercontinental Exchange Inc. (ICE)

6. Multi Commodity Exchange (MCX)

Top Traded Commodities

1. Mineral fuels, oils, distillation products, etc.

2. Electrical, electronic equipment

3. Machinery, nuclear reactors, boilers, etc.

4. Vehicles other than railway, tramway

5. Plastics and articles thereof

6. Optical, photo, technical, medical, etc. apparatus

7. Pharmaceutical products

8. Iron and steel

9. Organic chemicals

10. Pearls, precious stones, metals, coins, etc.

Types of Commodities

Commodities can generally be divided into four categories:

agricultural commodities such as grains and beans.

Agricultural

Agricultural commodities are staple crops and animals produced or raised on farms or plantations. Most agricultural commodities such as grains, livestock and dairy provide a source of food for people and animals across the world.

Commodities including crude oil, gold, silver, copper, platinum and corn.

Energy

The term energy commodities refer to a variety of coal, oil, and gasoline derived products. These include such energy sources as coal, Brent Sea Oil, gasoline, heating oil, and natural gas. These energy resources prove to be essential in daily life. This makes customers most aware of such commodities.

metal, silver, gold, aluminium and other stock market commodities.

Metals

Metal Commodities defines all mined minerals, which are standardized on regulated exchanges. These metals can be divided into two groups: Base Metals and Precious Metals. A base metal includes all metals which are mostly used for manufacturing purposes. This includes Metals, Aluminum, Copper, Lead, Nickel, Steel, Tin, and Zinc. Precious metals are more commonly used as investment tools or to store value in form of jewelry and other decorative items.  This includes Gold, Palladium, Platinum, and Silver.

A particular category in commodity trading of metals is concentrates. Concentrates is the material mostly straight from the mine, where the mined material is composed of multiple metal components such as copper, gold, zinc but also waste material. Concentrates can be traded and are depending on assays where multiple parties measure the actual contents of the mined materials.

Eco friendly industry concept.

Environmental

Environmental commodities are a class of commodities that take the form of non-tangible energy credits. The value of these credits derives from the needs of market participants to produce and consume cleaner forms of energy. The markets for these products formed as a result of government efforts to tackle greenhouse gas emissions (GHGs) and promote clean energy production and consumption. This category includes products such as carbon emissions, renewable energy certificates and white certificates.

Final Thought

There are a variety of commodities investments for beginner and expert traders to consider. Although commodity futures contracts provide the most shortest way to participate in price movements, other types of investments with varying risk and investment profiles also provide enough opportunities for commodities exposure.

Commodities can rapidly become risky investment propositions because they can be affected by worries that are difficult, if not impossible, to foresee such as uncommon weather patterns, epidemics, and disasters both natural and man-made.

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