Introduction to Commodities Trading 101

Why can’t a painting be considered a commodity? Because each one is unique. To be considered as a commodity, the object has to have uniformity, where one individual or portion serves the same purpose as another. An ounce of gold, a barrel of oil, a bushel of wheat. In every instance, one is the same as the other. There is no discernable difference whether a buyer receives one ounce of gold over another.

In some cases there are differences. Due to shipping costs, differences in composition, and so forth, some oil does sell for a different price than that from another source. Texas crude and North Sea oil are close enough for many purposes, but they trade on different markets and have different prices.

Commodities can be traded on either spot markets, or in the form of futures.

When you go to the local jewelry store and buy an ounce of gold, that's a spot trade. You hand the jeweler several hundred dollars in cash, he gives you an ounce of gold, usually in the form of a coin, 'on the spot'. Therefore spot markets are those in which the commodity is traded immediately in exchange for cash or some other good.

Other traders exchange commodities on spot markets in much greater quantities - thousands or millions of ounces of gold or barrels of oil. At some point, the actual good is delivered. After all, if the good is not received, and used, there was little point in the original purchase.

When futures (or options) are traded, it is not the good itself, but a contract to buy or sell the commodity for a certain price by a stated date in the future. Hence the name.

The largest profit and loss is made when commodities are traded in the form of futures or options. As it involves predictions of the future and hence uncertainty and risk, it is often the basis of the most interesting aspects of trading.

While commodities trading has been around for centuries, the modern markets began in the late 18th century when farming began to modernize. The basics remain the same, though the pace of trade and many of the detailed mechanisms have changed.

As an example, growing wheat took several months from planting to harvest to delivery and it still continues to take several months. A farmer might plant wheat in April and discover in June that the price someone is willing to pay for delivery in August has lowered during the past month.

A possible scenario follows. On May 1st wheat to be delivered on September 1st is selling for $4.00 per bushel. By June 1st, it has fallen to $3.80. If the farmer believes the price will continue to fall he can offer a contract on his wheat to be delivered on September 1st for $3.80 per bushel, locking in a price today at the current market level. In exchange, he accepts a legal obligation to deliver the wheat on or before September 1st.

Luckily for the farmer and others, some believe the price will in fact rise, instead of fall, and will trade at $4.20 per bushel by September 1st.

That kind of prediction is usually based on a very complicated analysis of current conditions, including the total amount of acreage under plant, soil moisture levels, weather predictions for the coming months, political events and many other variables at the time.

It’s called speculation because no one knows with any degree of certainty what the future price will be.

When September 1st arrives, the farmer delivers his wheat and is paid $3.80 per bushel. If the actual price turns out then to be $4.20 per bushel, the speculator makes a healthy profit. If instead the price is $3.50 per bushel, the speculator has lost money.

Neither complicated or simple, that's basically commodities trading.