How Commodities Trading Works

The Role of the Commodity Producer

Commodities traded on the various world markets produce products as diverse as gold, meat, cotton, oil and soybeans. At the time of extraction or planting, producers know their costs of production but not their ultimate sales price for the produced goods. The commodities markets arose in order to give certainty in advance to the seller and buyer of the commodity by locking in prices in the futures market. The efficiency of the market allowed many individual work units, such as farmers or miners, to combine their products into one fungible large market that would be traded competitively. The producers of the commodity gain foreknowledge of the price they can receive. This allows producers to adjust costs and technique according.to final demand. The long lead time allows sellers to project end demand for the products and consider the most efficient sales methods for maximizing revenue from the final distribution of the product.

The Creation of the Contract

Producers sell part of their production direct to middlemen and end users; the remainder is stored at locations qualified for futures trading. Commodities are traded according to units of contract specifications involving weight, quality, content and size. Contracts are written for X units of product, such as 1,000 oz. of gold, 5,000 bushels of soybeans or 1,000 55-gallon drum barrels of oil. Being fungible, each unit can be exchanged for any other and thus contracts added and subtracted. Each futures exchange specifies where the traded product must be delivered for storage until it is delivered. This definition of specifications, terms of delivery storage and delivery complete the transformation of commodities created worldwide into similar tradeable products that can be traded at a common price.

Commodity Traders and Speculators Try to Find Clearing Prices

Commodities are traded with deposits that rarely represent more than 20 percent (and often less) of the actual value of the contract they are trading. Thus, small price movements create major changes in equity. Traders believing the supplies will be at variance with anticipated demand will speculate with positions that are long (support the price rise) or short (believe the price is too high). More likely, traders will exploit small variances in contract delivery months and strike prices (delivery prices) with a variety of trading strategies. An important part of trading is called the carry. Carry represents the difference between the margin and the full value of the contract. As a result, the longer the maturity of the commodity contract, the greater the implied interest rate charged for the amount of the commodity carried, or not paid for in the future contract.

Resources

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