Updated on March 30, 2023
Investors interested in venturing into commodity markets must first learn how commodity markets work. However, before exploring that, here’s a brief introduction. A commodity market is a place that facilitates the buying, selling, and trading of raw materials or primary products. Commodities are typically divided into two categories: soft and hard commodities.
Hard commodities are those that must be mined or extracted, like gold, rubber, and crude oil. In contrast, soft commodities are agricultural or livestock products such as wheat, soya beans, coffee, sugar, etc.
Brief history of commodity markets
Trading commodities can be traced back to the beginning of human civilization when kingdoms exchanged valuable goods like food, supplies, and others through barter trade. Today, commodities are traded on exchanges throughout the world for the same reasons that our ancestors traded.
The Chicago Board of Trade (CBOT) is arguably the most influential commodities market. It was established in 1848 and originally traded only agricultural commodities like wheat, corn, and soybeans to manage the uncertainty farmers and consumers faced in the industry.
Today it includes the trade of options and futures on various products like gold, silver, U.S treasury bond, and energy products.
In 2007 The Chicago Mercantile Exchange (CME) group combined with the Chicago Board of Trade (CBOT), which resulted in the addition of interest rates and equity index products to the company’s offerings. The Chicago Mercantile Exchange acquired the Chicago Board of Trade (CBOT), the New York Mercantile Exchange (NYMEX), and finally, the Commodity Exchange (COMEX).
Types of commodity exchanges
In general, commodities either trade in spot or derivative markets. Spot markets are commodity markets where buyers and sellers enter spot transactions to immediately deliver the physical commodity.
These developed from commodity futures contracts into various financial instruments that can be used to trade every asset, including mortgages, insurance, and others. Derivatives markets feature forwards, futures, and options contracts.
Forwards and Futures contracts
Forwards and futures are derivative contracts that negotiate deals using the spot market as the underlying asset. Through these contracts, the buyer receives ownership of the asset at a specific time in the future, but they agree on the price today.
When the contract expires, physical delivery of the commodity or its representation is the next step. Although forwards and futures are similar, forwards are customizable and trade over the counter (OTC). Alternatively, futures are standardized and traded on exchanges.
This is a derivative in which participants exchange the cash flows from one party’s financial instrument for those of the other party’s financial instrument.
Exchange Traded Commodities (ETCs)
This is a term refers to commodity exchange-traded funds (ETFs) or exchange-traded notes (ETNs). They track the performance of an underlying commodity index as well as total return indices based on even a single commodity.
They have the same features as typical ETFs and investors trade them exactly like stock funds. Commodity ETFs majorly are index funds that track non-security indices. Because these funds don’t invest in securities, their regulation is not the same as that of investment companies in the U.S. However, they might be subject to the terms under the Commodity Futures Trading Commission.
The first commodity ETFs owned physical assets, such as SPDR Gold Shares: NYSE Arca: GLD and iShares Silver Trust NYSE Arca: SLV. However, most ETCs currently implement a futures trading strategy.
Over-the-counter (OTC) commodities derivatives
Initially, OTC commodities derivatives only involved two parties that traded without an exchange. However, exchange trading ensures transparency and regulatory protection. The difference with OTC trade is that the public doesn’t know the price beforehand. OTC commodities derivatives represent an increased level of risk but also lead to higher profits.
How commodity markets work
Commodity markets make it possible for producers and consumers of commodity products to access a centralized and regulated marketplace. Market participants such as speculators, investors, and arbitrageurs all play a vital role.
Through exchanges, buyers and sellers determine prices through spot transactions that result in immediate delivery of the physical commodity or its representation. Commodities traded on exchanges typically have few quality grades and are a desirable avenue for a large number of sellers and buyers. One of the key functions of exchanges is price determination.
For commodities that do not go through exchanges, buyers and sellers negotiate prices through auctions and bilateral contracts. The bilateral contracts are most common in international commodities trade.
In addition to money, commodity exchanges also utilise futures contracts traded in standardized sizes, terms, conditions, etc. The commodity exchange is responsible for creating a fair and easily accessible market for both parties to complete their transactions. Exchanges are similar to auction houses, where buyers and sellers meet and negotiate.
In conclusion, commodity exchanges support the trade of commodities through spot transactions, futures, forwards and swaps, Exchange Traded Funds, and over-the-counter commodities derivatives. As an investor interested in participating in the commodities market, you must conduct your research before investing.
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