What is a Commodity?
Everyone buys and sells goods and services of all kinds and in general anything that is exchanged is a commodity. The word "commodity" has a special meaning in the financial world. Commodities are raw materials, rather than finished products, and trading in commodities futures contracts is an important part of economic activity. This article traces the origins and types of commodities that are traded on exchanges like the Chicago Board of Trade and explains the basics of how a commodity futures contract works. There is a link under resources to get more information.
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History
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The purpose of commodity futures is to reduce uncertainty in the prices of raw materials and traces its history back to the 16th century. In a day when half of the European ships sent to the Far East to bring back spices never returned, investors sought ways to reduce risk. Modern commodity trading began in the mid-19th century, principally in Chicago. Farmers and dealers in livestock, grain, and other agricultural products wanted a reliable way to set prices. Beginning in 1848, people began to grade grain and other agricultural products to make setting prices easier. Farmers and buyers would often sign contracts in which the farmer agreed to deliver his harvest at a guaranteed price, enabling him to get credit to raise the crop. Dealers got the assurance of a future delivery at a firm price. Out of this custom, commodity trading exchanges like the Chicago Board of Trade gradually evolved. The futures market is still based on those contracts, but has become a favorite market for speculators seeking profits by trading futures contracts.
Types
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There are many different raw materials that are traded through futures contracts. Agricultural products include grains, livestock, orange juice, and fibers like cotton. Metals, including precious metals like gold and silver, form another category. Still another is energy, or more specifically the raw materials needed to produce energy like oil, natural gas, uranium, and a recent addition, ethanol.
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Features
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The heart of commodity trading is the futures contract. One party agrees to buy a certain amount using a standardized contract (for example, 5000 bushels of wheat) and the producer agrees to sell the commodity at that price on a specified future date. However, futures contracts are traded on commodity exchanges like the Chicago Board of trade. When a commodity trader buys a futures contract, it can be either as the seller (a "put" contract) or a buyer (a "call" contract). When it's a call contract, the trader hopes the price will rise because the contract can then be sold at the higher price, resulting in a profit. The buyer of a put contract hopes the price will fall, because then he/she can pay less to complete the sale in the future than the original cost of the contract.
Significance
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Eventually the producers of raw materials deliver their product and receive payment and the futures contracts are all settled, whoever they end up belonging to. Because of this a futures contract always has a settlement date and is a short term financial transactions. For the buyers and producers who create the original contracts, uncertainty is reduced by shifting risk to the speculators who trade in futures contracts. What makes commodity futures trading so alluring to speculators is that it is done on margin. This means a trader puts down a small part of the price of the contract (typically 5 to 10%). If the price changes by a few percentage points, it's possible to double your money in just a few days---or lose all of it just as fast.
Considerations
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Beginners in commodity futures trading should be extremely cautious. Since futures contracts are traded on margin this is a high risk form of market speculation and most people lose money at first. There are ways to reduce risk, however. For example, many traders routinely place a "stop sell" order at a price above or below the purchase price of the contract. If the price goes the wrong way, the contract is automatically sold, limiting losses. Anyone interested in trading in commodity futures should understand this and other strategies and be knowledgeable about the commodities they trade. Finally, realize that trading futures contracts requires constant attention and should never be more than a small part of an investment/moneymaking plan due to the high risk involved.
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