The commodities market at its most basic works by buying and selling commodities based purely on price. A definition of commodities can be seen in the attached short video.
These tradeable assets are bought and sold on commodities exchanges, with prices determined by supply and demand. There is generally no distinction between brands or benefits on the commodities market – for example, gold sourced from the US has the same value as gold sourced from Africa.
Domen Zavrl has a background in finance and counts commodities trading among his main areas of expertise. While the fundamentals of the commodities market are relatively easy to understand, there are various financial instruments at play within this market that place a different slant on simple trades.
Early Commodity Trading
Commodities trading in its most basic form dates back to the earliest civilizations, when citizens would exchange tokens for goods such as livestock at market. This system evolved and was improved upon over time, leading to the development of trading markets using gold and silver in classical civilizations.
This trade in gold and silver would eventually lead to the development of money, with coins valued by weight. The first recognised stock exchange in the world, the Amsterdam Stock Exchange, began life as a commodities market. From its launch as a stock exchange in 1530, traders developed financial instruments that are still used today on the global commodities market, including options, short sales and forward contracts.
Forward contracts are widely traded within the global commodities market today. These types of contract allow for the trading of goods at a set price but on a future date. The contract outlines the terms and conditions of the exchange, which includes the date it is to take place, the agreed price to be exchanged for the goods, and the quality and quantity of the goods to be supplied.
Options evolved from forwards contracts when the buyers of the contracts began to sell their right to purchase to third parties. A secondary market was created where investors who had bought forward contracts from farmers at market sold those contracts to other investors, exchanging the right to receive the goods in question in the hope of making a profit.
Options traders are typically not end users of a product; they purchase the contracts with the aim of selling them on, essentially betting on which way they think the price of the goods will fluctuate during the length of the contract.
Futures contracts are a very specific type of forwards contract, in which the terms of the transfer are formalised on an organised commodities exchange. The exchange sets out specific terms to be included within the futures contract, including dates when transactions must be settled by and minimum quantities of goods that can be offered to bid on. Futures contracts are available across every commodities category. The embedded infographic shows the four main categories of commodities that are traded.
Manufacturers and providers of services can use futures contracts to help minimise their own business risk by hedging against future changes in price than might otherwise result in a loss of profit. Investors or speculators use futures contracts in the hope of making a profit from fluctuations on market prices. Investors must have a brokerage account or broker that specialises in futures to be able to trade in these types of forward contract.
You can find some tips on choosing a first broker in the PDF attachment to this post.