Commodities Market 101
New to the Commodities Market?
Perhaps you're just curious and desiring to know more about how the whole thing works....or you want background on the development of the modern commodities market.
On this page, you'll learn about these fascinating markets,which power the worlds' economies...and from which much of our lives - - - food, clothing, shelter, transportation, etc. - - - is based.
Commodity Market Page Outline:
- The Commodity Market and Commodities
- The Role of the Markets
- How does Commodity Trading work?
- Modern Commodity Market Evolution
- Commodity Market Contracts
...and The Commodities Market
So, you want to know about and understand the commodities market. Let's start at the beginning.
The terms commodity market, commodities market and future(s) market mean the same thing and can be/are used interchangeably.
There are a number of specific commodities and commodity groupings. Examples of different commodities market groupings or families include the following:
- Agricultural commodities include raw "grains" like corn, oats and wheat.
- In the metals commodity market, gold, silver, copper, platinum, aluminum, etc are some of the main raw metal commodities.
- Meat commodities are raw products like pork bellies and live cattle.(Bacon comes from pork bellies)
There are also the 'soft' commodities, including Orange Juice, Coffee, Sugar and Lumber.
And Energy commodities, including Crude Oil, Gasoline, Heating Oil.
Financial commodities include Treasury Bills, T-Bonds and Currencies.
These commodities (among numerous others) make up the core of what is traded on the commodity market or future market.
There are multiple futures commodity marketplaces or exchanges serving the different raw commodities or commodity groups. And certain commodities are traded on specific exchanges.
Transactions between buyers and sellers for specific raw commodities occur at futures commodity exchanges serving the different raw commodities or commodity groups.
The Chicago Board of Trade (CBOT), London Metals Exchange(LME) and the Chicago Mercantile Exchange(CME)are examples of some of the major commodity futures exchanges.
The agreement tying a futures buyer and seller together on a commodities market trade is the futures contract.
It stipulates the commodity, the purchase or selling price (depending on whether you think the price to rise or fall), the quantity of contracts being bought or sold,the length of the contract, and delivery date/terms.
As individual speculators interested only in profiting from commodity price moves, we are not interested in taking actual delivery of the physical commodity...and will plan to exit the futures contract trade before it's specified delivery date.
The Commodities Market Role
The main role of futures market(s) is to allow two important groups...
...Commercial Commodity Producers, and Commercial Commodity Consumers...
...to minimize the potential of adverse future commodity price movements on their respective businesses down the road.
To begin to understand the important role of futures market trading, consider the following short overview:
In the case of grain commodities like corn and wheat, the the farmers and farm cooperative organizations are the commercial commodity producers. They plant, harvest and sell their corn.
Commercial Commodity Consumers could be cereal companies,
bread manufacturers and other commercial firms who take the raw corn commodity and refine/turn it into a final end product that they sell to
retail end-users/consumers like you.
All parties want something out of the deal. Upstream producers want to hedge their crop against potential falling prices when harvest time comes.
Commercial Commodity Consumers want to lock in a good price today for future delivery of raw commodities like corn, in the case of rising prices
in the meantime.
And individual traders like you, hope to profit on either rising or falling commodities prices via trading futures contracts, exit trades before the contract delivery date...hopefully with a profit.
In a nutshell, that's the important role of futures market and commodities market exchanges play, bringing futures speculators hedgers and producers together.
How Future Markets Work
...A Detailed Example
How does this whole Future Commodities Market thing work?
Let's take the above short example and expand on it.
A Corn farmer wants to protect himself from possible future declining prices and a potential loss at harvest time.
What does he do?
Well, the farmer has 'x' cost into planting, growing and harvesting his Corn crop. He wants to get his cost back plus hopefully a profit on it.
But his crop won't be ready to harvest and sell for 6 months.
All sorts of factors like weather temperature, rain, drought, higher or lower yields from competing international producers could impact his Corn crop and the final price he'll be able to get for it...IF he sold it 6 months later.
So, he agrees to sell his Corn in the future markets to a Commercial Producer TODAY, for a set specified price per bushel...for delivery 6 months later.
The farmer wants to ensure he doesn't lose money should the overall market for his crop produce a glut, depressing commodity prices at harvest time.
Now, if there's a short supply (and high demand) of his Corn at harvest time, his crop would be worth even more money in the future market
...IF he sold it at harvest time.
So in this case, the farmer would lose what would have been a higher profit for his crop, had he waited to sell his crop at harvest...but he still came out to the good, locking in a good price to cover his costs and a profit by trading in the future markets 6 months ahead of harvest time.
But, what if there was an unexpected supply glut of his commodity at harvest?
We'll, he's still to the good, protecting himself by locking in a pre-determined profit for his Corn when he agreed to sell his crop 6 months earlier at planting time.
The same scenario works for the Commercial Commodity Producer
...from the other side of the coin
This Corn Chex cereal producer wants to lock in the lowest price he can for his raw Corn commodity...just in case the farmer has a crop shortage/resulting in high demand and rising prices at harvest.
Should that happen in the future, he has to pay a lot more for the Corn,
...IF he were to wait and buy at harvest time.
Waiting, in this case, could cause his profits to be negatively impacted no matter how many boxes of Corn Chex cereal he sells. He might even take a loss if potentially higher commodity Corn costs drive his total cost to make the cereal beyond what he can sell the cereal for.
The cereal maker wants to avoid this negative potential, so he agrees to buy the corn he needs in the commodities market, and locks in a price months earlier at planting time, for delivery in 6 months.
If the farmers' crop harvest results in a future supply glut and declining commodity prices, the cereal maker could have bought the commodity at an even lower price...by waiting until harvest time,...and made more profit on sales of his Corn Chex.
But, he wasn't willing to take the upfront risk of a supply shortage occurring months later at harvest, potentially costing him money and lower profits later on....so he locked in a reasonable price at planting 6 months earlier by trading in the commodity future market.
'Hedging' his bet, this ensures the cereal maker still makes a profit on each box of cereal, by locking in a good price months before the corn commodity harvest.
Bottom line? - both Commercial parties got what they wanted out of the trade. They're both more concerned with minimizing their future risk than maximizing their profits.
The farmer protected himself from possible future declining prices and a potential loss in that event...locking in an acceptable price and delivering his crop to the cereal maker6 months later.
And the cereal maker protected himself from possible future rising commodity prices and potential lower profits...or even potential loss...by agreeing to buy the farmers crop at an acceptable price 6 months earlier, taking delivery at harvest time.
As speculators, we hope to profit from rising or falling prices in the commodity market during the 6 months we're trading our corn futures contract, depending on the direction we feel the market will move.
But unlike the Commodity Producer and Consumer who want to minimize risk, speculators want to MAXIMIZE profits.
Thus, we take on greater risk trading the future market to hopefully capture maximum trading profits - but with no guarantee of success.
In any case, we exit our futures contract in the commodities market before the end of the delivery date 6 months later, as we don't want to take physical delivery of 5000 bushels of corn!
Hopefully this detailed example gives you a better understanding of the important role of futures market trading in the lives of various players who engage in trading both the physical raw commodity and speculators trading contracts in the commodity market.
For more info on Futures Contracts click here
Modern Commodities Market Evolution
Agricultural mechanization and the Industrial Revolution were two of the key drivers in how today's modern future commodities market(s) evolved.
This began about 160 years ago, around the mid-1800's.
First, in agriculture, a father-son duo invented a machine that would forever change the American farm landscape, and ultimately farm landscapes, crop production and harvesting worldwide.
Completed by the son, Cyrus Hall McCormick Sr, "the Reaper" was tested in 1831 and patented in 1834.
It revolutionized the harvesting (and subsequent growth) of the wheat (and other) agricultural commodities in the expanding, centrally located 'American Heartland'.
In the late 1840'sCyrus and his brothers moved from Virginia to Chicago. The McCormick Reaper experienced growing sales and popularity, becoming the foundation of his McCormick Harvesting Machine Company and related farm implement manufacturing. (It became part of International Harvester in 1902).
Previous to this time and the development of the American commodities future market, growing, selling and buying agricultural crops was a hit or miss proposition.
Midwestern farmers had no idea of crop demand when they came to Chicago to sell their goods.They just hoped to get a good price.
Unlike today, at that time there were there hardly any centralized and standard process for weighing the farmers crop, much less grading its' quality.
Unfortunately for the farmer, it was the early agricultural commodity dealers who had the upper hand. The farmer basically took whatever price he could get from the dealer.
And, as there were few available grain commodity storage facilities, unsold crops - in the event of oversupply and lower demand - went to waste
in the streets.
Due to Chicago's central geographic location - already a bustling commercial center - it became the main hub between the heavily populated East Coast cites and the Midwestern farms
And the appearance of the "Iron Horse" (railroads)in the 1840's ushered in a vastly improved and far more efficient way to move goods between farms and the city populations.
Then, around the mid 1800's, a central grain commodity marketplace was created and central grain commodities market was established.
Farmers now had a central grain commodities market where they could sell their larger wheat and other agricultural crop yields directly and immediately to broker dealers for cash. 'On the spot' so to speak.
Railroads in and out of Chicago gave farmers a wide distribution vehicle for shipping their crops countrywide.
And Brokers or dealers acted as the middle men, bringing buyer and seller together in what became the forerunner to today's physical commodities market or cash future market.
Commodity Market Contracts Evolution
In addition to farmers immediately selling/exchanging their grain commodities for cash in the newly established commodities market...forward delivery was another available option.
These 'forward contracts' were the harbingers of today's futures contracts.
Many of these forward contracts were straightforward deals
(think "buy now, pay and deliver later") between two parties, and were not traded on exchanges.
These forward contracts evolved (into the more standardized forms of today's futures contracts we trade today on exchanges), as more and more farmers began committing their grains to futures exchanges for cash.
In some cases if producer changed his mind or circumstances changed, and he no longer needed the commodity, he'd sell it to another producer who did.
Or maybe the farmer changed his mind, not wanting to sell his commodity, and he passes on his obligation to deliver that commodity to another farmer who would sell and deliver it.
This dynamic, coupled with many 'fundamental' supply and demand factors which affect a commodity price during the contract period, led to the rise of price speculation and individual futures traders.
Which brings us to today, were we, as individual speculators have no interest of buying or selling the actual commodity.
Instead, we trade commodities future contracts in the future market to profit from the underlying commodities price movement.
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