Commodities are basic or raw goods that are traded almost solely on price and whose prices are usually set through open market trading. Common examples are:
Sometimes currency and market-index contract trading is also considered a form of commodity trading, although these types of instruments are not based on any physical commodity.
Commodities may be traded directly on a spot or cash market, in which the physical good is delivered to the buyer, or indirectly on a futures market, in which a financial contract between buyer and seller specifies a future date, price, and other terms at which the goods would hypothetically be traded. A variety of financial instruments and derivatives are used in commodity trading, including futures contracts, leverage contracts, options on futures contracts, options on physicals, managed accounts, commodity pools, funds, limited risk forward accounts, deferred delivery contracts, bank-financed forward accounts, gold or silver bullion contracts, and long-term forward accounts.
Such diverse and complex financial arrangements have evolved to give buyers and sellers of commodities the flexibility to insulate themselves from adverse price movements, a practice known as hedging. Hedging and other protections are an important component of commodity trading because the markets are notorious for wild price swings, which may be devastating to producers dependent on commodity income or to buyers dependent on the raw materials. Indeed, the vast majority of commodity transactions on the major commodity exchanges are only paper transactions in which the underlying goods never change hands.
Competitive price discovery is another major economic function and benefit of futures trading. The trading floor of a commodity exchange is where information about the future value of a commodity or item is translated into the language of price. Commodity prices are volatile because they are subject to many factors, among them weather, strikes, inflation, foreign or international exchange rates, new technology, politics, transportation, and storage factors.
While many commodity traders have a vested interest in the underlying products they trade, a large number of futures and options traders do so purely for investment growth; if they can accurately anticipate the future direction of commodity prices, they can make substantial profits in futures markets. Unlike in cash markets, where investors only profit when prices rise, in futures markets investors may reap gains when prices fall as well, depending on the type of contract they trade. This added flexibility forms the basis of hedging, but also allows for contrarian investment strategies that assume prices of a certain good (or stocks, currencies, etc.) will fall.
Two types of futures contracts exist: those that provide for the physical delivery of a particular commodity, also known as spot trading, and those that call for a cash settlement, known as futures or forward trading. Even though delivery on futures contracts is the exception rather than the rule, the delivery provision exists because it affords buyers and sellers the opportunity to take or make delivery of the physical commodity. Also, the fact that delivery can actually take place helps to ensure that futures prices accurately reflect the cash market value at the time the futures contract expires.
If delivery does take place, it takes the form of a negotiable instrument, such as a warehouse receipt, that proves the holder's ownership of the commodity at some designated location. Cash settlement futures contracts are settled in cash rather than by delivery and are based on a given index number times a specified dollar multiple.
The first organized commodity exchanges in the United States date back to the 19th century. The Chicago Board of Trade (CBOT), founded in 1848, is the oldest U.S. futures exchange. When it was first established, the CBOT was a centralized cash market, formed in response to the need for a central marketplace that would bring together large numbers of buyers and sellers, thus providing liquidity, as well as providing a place with rules for ethical trading practices and reliable standards of weights and measures. Soon after the founding of the exchange, grain brokers began trading in "cash forward contracts," in order to assure buyers a source of supply and sellers the opportunity to sell 12 months a year. As the use of the cash forward contracts escalated, the futures contract, as it is known today, evolved. Futures contracts differed from cash forward contracts in that they specified the price at the time the contract was made, as well as the quantity, quality, and delivery time.
Commodity contracts are based on standard quantities of the underlying good; one cannot purchase a contract for any other quantity. For example, one soybean contract is equivalent to 5,000 bushels of soybeans, or one contract of gold is equivalent to 100 troy ounces of gold. Buyers and sellers may, of course, trade many contracts at once on the same terms.
Commodity exchanges likewise establish the minimum amount that the price can fluctuate upward or downward. This minimum amount is known as the tick. The exchanges also establish daily price limits, which are stated in terms of the previous trading day's closing price, plus or minus a specified amount per trading unit. Once a futures contract price has increased or declined by its daily trading limit, trading cannot take place at prices beyond this limit. For some contracts, daily price limits are not imposed during the month in which the contract expires.
Futures prices are usually quoted the same way that prices are quoted in the cash market, when a cash market exists. This means dollars, cents, and often fractions of a cent, per bushel, pound, or ounce. For foreign currency futures, prices are quoted in dollars, cents, and increments of a cent. For financial instrument futures, prices are quoted in points and percentages of a point. Cash settlement futures contract prices are quoted in terms of an index number, usually stated to two decimal points.
Buckley, John, ed. Guide to World Commodity Markets. 7th ed. London: Kogan Page Ltd., 1997.
Chicago Board of Trade. Commodity Trading Manual. Chicago: Glenlake Publishing, 1998.
Futures Industry Institute. Introduction to the Futures and Options Markets. Washington, 1998. Available from www.fiafii.org/tutorial/toc.htm .