The financial term commodity is defined as a physical substance, such as food, grains, a and metals, which is interchangeable with other product of the same type, and which investors buy or sell, usually through future contracts. Or more generally, a product which trades on a commodity exchange; this would also include foreign currencies and financial instruments and indexes. When one speaks of a commodity, they can be referring to two types of this aspect of finance. A cash commodity or an actual is an actual physical commodity which is delivered at the completion of a “contract” This is the lesser utilized of commodities.
The more predominant type of commodity that is used is the commodity futures contract. The futures markets are described as continuous auction markets and exchanges providing the latest information about supply and demand with respect to individual commodities, financial instruments, and currencies. Futures exchanges are where buyers and sellers of an expanding list of commodities, financial instruments, and currencies, come together to trade. (Investors Glossary)
The primary purpose of futures markets, is to provide an efficient and effective mechanism to manage price risk. The futures market allows buyers and sellers to stabilize the price of something. Individuals and businesses seek to achieve insurance against adverse price changes. This is done by buying or selling futures contracts, with a price level established now, for items to be delivered later. A common practice amongst the traders of futures is called hedging. The details of hedging can be somewhat complex but the principle is simple.
Hedgers are individuals and firms that make purchases and sales in the futures market solely for the purpose of establishing a known price level-weeks or months in advance-for something they later intend to buy or sell in the cash market (such as at a grain elevator or in the bond market). In this way they attempt to protect themselves against the risk of an unfavorable price change in the interim or hedgers may use futures to lock in an acceptable margin between their purchase cost and their selling price(Castle Trading)
A perfect example of how the futures trading works is provided in the agricultural form of commodities. For example, a food manufacturer will need to buy additional corn from his supplier in three months. However, he feels that the price of corn is going to increase by the time he needs the corn in three months. Because of fierce competition, he needs to hold his price constant. He wants to make sure that he pays $3. 55 per bushel. Therefore, to lock in the $3. 55 per bushel price, he buys a contract for three months out at $3. 55 per bushel.
If three months later the price of corn has risen to $3. 69 per bushel, he will pay his supplier $3. 69. However, the 14 cent increase has been offset by the 14 cent increase in his futures contract. On the other hand, if the price of corn declines by an amount of 10 cents per bushel to $3. 45 per bushel, the decline in the futures contract will be offset by the lesser amount the manufacturer has to pay his supplier. Irrespective of what happens in the spot market, the manufacturer has locked in a set price for the corn he needs to purchase in the future.
Marketing Terms) One may ask themselves, what was the basis for this practice of the trading of futures and commodities. Before there were organized grain and commodity markets, farmers would bring their harvested crops to major population centers. There they would search for buyers. There were no storage facilities; and many times the harvest would rot before buyers were found. Also, because many farmers would bring their crops to market at the same time, the price of the crops or commodities would be driven down. There was tremendous supply in relation to demand.
The reverse was true in the spring. Many times there would be a shortage of crops and commodities and the price would rise sharply. There was no organized or central marketplace where competitive bidding could take place. (EH. Net) Futures prices and the bid and asked price are continuously transmitted throughout the world electronically. Regardless of what geographic location the speculator or hedger is located in, he has the same access to price information as everyone else. Farmers, bankers, manufacturers, corporations, all have equal access.
All they have to do is call their broker and arrange for the purchase or sale of a futures contract. The person who takes the opposite side of your trade may be a competitor who has a different outlook on the future price, it may be a floor broker, or it could be a speculator. Commodities are basically broken down into five specific categories: The first type of agricultural contract is the grains. This group includes corn, oats, and wheat. The second type of agricultural contract is the oils and meal. This group includes soybeans, soymeal, soyoil, sunflower seed oil, and sunflower seed.
The third group of agricultural commodities is livestock. This group includes live hogs, cattle, and pork bellies. The fourth type of agricultural commodities is the forest products group. This group includes lumber and plywood. The fifth group of agricultural commodities is textiles. This group includes cotton. The last type of agricultural commodity is foodstuffs. This group includes cocoa, coffee, orange juice, rice, and sugar. For each of these commodities there are different contract months available. There are also different grades available.
And there are different types of the commodity available. Contract months generally revolve around the harvest cycle. More actively traded commodities usually have more contract months available. Almost every month a new type of contract appears to meet the needs of a continuously growing corporate and institutional market. (Marketing Terms) The group of metallurgical commodities includes the metals and the petroleum’s. The metals group includes gold, silver, copper, palladium, and platinum. The petroleum group includes crude oil, gasoline, heating oil, and propane.
Different contract months, grades, amounts, and types, of these contracts are available. Almost every month a new type of contract appears to meet the needs of a continuously growing corporate and institutional market. (Marketing Terms) This group of futures only began trading in 1975. Yet it is this group that has seen the most explosive growth. This group of futures contracts includes Treasury Bills, Treasury Bonds, Treasury Notes, Municipal Bonds, and Eurodollar Deposits. The entire yield curve is represented and it is possible to trade these instruments with tremendous flexibility as to maturity.
In fact, it is also possible to trade contracts with the same maturity but different expected interest rate differentials. In addition, foreign exchanges also trade debt instruments. Almost every month a new type of contract appears to meet the needs of a continuously growing corporate and institutional market. (CNN Financial) Today, there are futures on most major indexes. The S&P 500, New York Stock Exchange Composite, New York Stock Exchange Utilities Index, Commodities Research Bureau (CRB), Russell 2000, S&P 400 Midcap, Value Line, and the FT-Se 100 Index (London).
Stock index futures are settled in cash. There is no actual delivery of a good. The only possibility for the trader to settle his positions is to buy or sell an offsetting position or in cash at expiration. Almost every month a new type of contract appears to meet the needs of a continuously growing corporate and institutional market. (CNN Financial) In the 1970’s when freely floating exchange rates were established it became possible to trade foreign currencies. Most major foreign currencies are traded.
The principal currencies traded are the Canadian dollar, Japanese yen, British pound, Swiss franc, French franc, Eurodollar, Euromark, and the Deutsch mark. The forward market in currencies is much larger than the foreign exchange futures market. Additionally, there are now cross currency futures that trade. Examples of these are the Deutsch mark/French franc and the Deutsch mark/yen. Almost every month a new type of contract appears to meet the needs of a continuously growing corporate and institutional market. (Marketing Terms)
The world of commodities is one in which a variety of people come together in order to make their economic situation somewhat more efficient. Whether they come in the form of hedgers who are trying to control the price of a commodity or speculators who are just looking to make the extra buck, commodites and futures offer something to everyone. It is a method for people, like you and I, to invest in tangible products that we feel are going to make a profit in the market. It is an exciting business that is always changing and is one that has sparked great interest in many people.