COMMODITY MARKET

EFINITION
A commodities market is a physical or virtual marketplace where raw or primary
products are traded. These products are typically natural resources or agricultural
products that are largely uniform in quality across producers. Examples include oil,
gold, wheat, coffee, and livestock.
A commodity market is where you can buy and sell goods taken from the earth—
from cattle to gold, oil to oranges, and orange juice to wheat. Commodities are
turned into products like baked goods, gasoline, or high-end jewelry, which in turn
are bought and sold by consumers and other businesses. Markets in these goods are
the oldest in the world, but they are as crucial to the most modern societies as they
were to the small trading communities of ancient civilizations.

Commodities are split into two broad categories: hard and soft commodities. Hard
commodities include natural resources that must be mined or extracted, such as
gold, rubber, and oil, while soft commodities are agricultural products or livestock,
such as corn, wheat, coffee, sugar, soybeans, and pork. They are traded directly in
spot markets or financial commodity markets through contracts for them or their
future prices.

KEY TAKEAWAYS

 A commodity market involves buying, selling, or trading raw products like

oil, gold, or coffee.
 There are hard commodities, which are generally natural resources, and soft
commodities, which are livestock or agricultural goods.
 Spot commodities markets involve immediate delivery, while derivatives
markets entail delivery in the future.
 Investors can gain exposure to commodities by buying them on the market,
investing in companies that produce them, or putting money into futures
contracts whose value is derived from changes in their price.
 The major U.S. commodity exchanges include ICE Futures U.S., the
Chicago Board of Trade (CBOT), the Chicago Mercantile Exchange (CME),
and the New York Mercantile Exchange (NYMEX).
How Commodity Markets Work

Commodity markets have existed since very early in human history. They were
and still are found in bustling town squares or along ports where traders and
consumers buy and sell grains, haggle over livestock and meat, or try to leave
some money to spare to purchase whatever else came in with the harvest. These
traditional markets have served as the physical backbone for exchanging the raw
materials upon which societies were built and on which we survive.

Yet, alongside and within these markets, there is the parallel world of financial
commodity markets. Here, traders don't swap bushels of wheat or bales of cotton.
Instead, they agree on the future prices of these goods through contracts known as
forwards, which were standardized into futures and options contracts in the 19th
century.

Without these markets, farmers couldn't ensure they get the prices they need for
their harvest to plant seeds the following year. So the regular commodity market is
intertwined with trading in the financial commodity markets, which exert
extraordinary influence on our daily lives. These financial markets don't directly
handle the commodities themselves—though a trader may be on the hook for
delivering them in the future—but enable trading in interchangeable agreements in
regulated exchanges. These markets help airlines hedge against rising fuel costs,
farmers lock in grain prices ahead of their harvest, and speculators wager on
everything from gold to coffee beans.12

Producers and consumers of commodity products can access them in centralized

and liquid commodity markets. These market actors can also use commodities
derivatives to hedge future consumption or production. Speculators, investors,
and arbitrageurs (the latter try to profit from small price differences between
markets) also play an active role in the commodities trade.

The U.S. Commodity Exchange Act (CEA) from 1936 provides this thorough
definition of commodities, which include both physical products and the contracts
traded for them:

The term “commodity” includes wheat, cotton, rice, corn, oats, barley, rye,
flaxseed, grain sorghums, mill feeds, butter, eggs, Solanum tuberosum (Irish
potatoes), wool, wool tops, fats and oils (including lard, tallow, cottonseed oil,
peanut oil, soybean oil, and all other fats and oils), cottonseed meal, cottonseed,
peanuts, soybeans, soybean meal, livestock, livestock products, and frozen
concentrated orange juice, and all other goods and articles, except onions as
provided in Public Law 85–839 (7 U.S.C. 13–1), and all services, rights, and
interests in which contracts for future delivery are presently or in the future dealt
in.3
Certain commodities, such as precious metals, are purchased as a hedge against
inflation, and the broad set of commodities themselves are an alternative asset class
used to help diversify a portfolio. Because the prices of commodities tend to move
inversely to stocks, some investors also rely on commodities during periods of
market volatility.4

Types of Commodity Markets

Commodities trade either in spot markets or financial commodity or derivatives

markets. Spot markets are physical or “cash markets” where people and companies
buy and sell physical commodities for immediate delivery.

Derivatives markets involve forwards, futures, and options. Forwards and futures
are derivatives contracts that rely on the spot prices of commodities. These
contracts give the owner control of the underlying asset at some point in the future
for a price agreed upon today.

Only when the contracts expire would physical delivery of the commodity or other
asset take place, and often traders roll over or close out their contracts to avoid
making or taking delivery altogether. Forwards and futures are generally the same,
except that forwards are customizable and trade over the counter, while futures are
standardized and traded on exchanges.4

A commodity option is a financial contract that gives the holder the right, but not
the obligation, to buy or sell a specific amount of a particular commodity at a
preset price (called the strike price) on or before a specific date (the expiration
date).

There are two main types of commodity options:

1. Call options: Give the holder the right to buy the commodity
2. Put options: Give the holder the right to sell the commodity

These options are used by traders and businesses for various purposes, including
the following:

 Speculating on changes in price

 Hedging against price shifts
  Managing risk in commodity-dependent industries1

History of Commodity Markets

Trading commodities goes back to the dawn of human civilization as loosely

affiliated villages and clans would barter and trade with one another for food,
supplies, and other items. The rise of empires across the ancient civilizations of
Africa, the Americas, Asia, and Europe can be directly linked to their ability to
create complex trading systems and facilitate the exchange of commodities across
vast territories via major trade routes like the Silk Road.

Today, commodities are still exchanged worldwide—and on a massive scale.

Trading has also become more sophisticated with the advent of exchanges
and derivatives markets. Exchanges regulate and standardize commodity trading,
making trade in these goods and contracts far more efficient.

The majority of exchanges carry at least a few different commodities, although

some specialize in a single group.
Commodity markets in the U.S. stretch back to the earliest colonial days—in fact,
the goods bought and sold were largely the impetus for European colonialism in
the first place—and centralized marketplaces eventually emerged in bustling cities
to trade tobacco, timber, and grains. Early on, farmers and merchants relied
on forward contracts to manage costs when there were problems in supply chains.5

The CBOT, founded in 1848, standardized how grain futures were traded. Other
specialized exchanges arose for cotton, livestock, and metals. The exchanges
brought badly needed transparency and structure to chaotic markets where
"corners" (as in "cornering" the market) weren't banned until 1868.2 Shady
operations dubbed "bucket shops" preyed on the inexperienced, leading to losses
and a lack of faith in the markets. In response, states enacted a patchwork of
legislation, including some that banned commodity derivatives (options and
futures) altogether.

The Grain Future Act of 1922 was a turning point.6 The law established reporting
requirements and attempted to limit the massive price fluctuations of the era by
mandating that all grain futures be traded on regulated futures exchanges.

Still, in the turbulent years moving into the 1930s, the American commodity
markets had many well-publicized scandals. Speculators fueled wild price swings
that threatened to crush farmers and starve those already facing the ravages of the
Great Depression. In light of these stark circumstances, the CEA was enacted in
1936. Its most tangible result was establishing the Commodity Exchange
Commission (CEC) as an independent agency under the Department of
Agriculture.

The CEC was given regulatory muscle to set licensing standards for exchanges and
brokers, regulate trading practices, and tighten policies to safeguard investors.
Most important among these would be the CEC's monitoring of significant market
positions to enforce trading limits and preempt attempts to corner the market or
engineer chaotic price swings.2

Commodity trading done outside exchanges is in the over-the-counter market.

In the following decades, the CEC's authority expanded to cover more and more
commodities. By the early 1970s, Americans were facing higher fuel costs, rising
unemployment, and an economy teetering toward what would become
the stagflation of the 1970s. In 1973, grain, soybean, and other futures prices hit
records, with the blame put on speculators in the market. This led to amendments
to the CEA in 1974 that created the Commodity Futures Trading Commission
(CFTC) and expanded its remit to include precious metals and financial futures.74

These regulatory attempts laid bare the fundamental tension in commodity

markets. How to rein in excessive speculation and shut down manipulative
practices while allowing these markets to enable legitimate trade and price
discovery? The CFTC inherited the oversight duties outlined in the heavily
amended CEA.

However, it encountered a growing universe of complex financial products,

including options, foreign currency futures, and the mushrooming interest rate
derivatives market. Early successes in cracking down on fraud and protecting
market participants were punctuated by occasional scandals. For example, in 1978,
the CFTC had to ban so-called "London options" because of fraud, and the next
year halted trading in March wheat futures to stop price manipulation in that
market. Such events revealed the ongoing battle between regulators and
sophisticated players seeking to exploit any new opportunity.

Technological revolutions transformed the industry as computerized and

eventually network-driven trading became the norm. In 2008, the financial crisis
and the tripling in price of wheat futures sparked calls for further and more
stringent regulations.8 The Dodd-Frank Wall Street Reform and Consumer
Protection Act of 2010 expanded the CFTC's jurisdiction to include over-the-
counter derivatives like swaps.7
Today, U.S. commodity exchanges list options and futures contracts on a wide
range of products, including gold, silver, U.S. Treasury bonds, energy, and
weather-related and other events. In 2007, the CME Group merged with the
CBOT, adding interest rates and equity index products.9 The same year, the New
York Board of Trade merged with Intercontinental Exchange (ICE), forming ICE
Futures U.S.1011 Finally, in 2008, the CME acquired the New York Mercantile
Exchange (NYMEX) and the Commodity Exchange Inc.1213 Each exchange
offers a wide range of global benchmarks across major asset classes.

Examples of Commodities Markets

Most major commodity exchanges in the U.S. are in Chicago and New York,
where they specialize in particular commodities or a whole range of them. For
example, commodities traded on the CBOT include corn, gold, silver, soybeans,
wheat, oats, rice, and ethanol.14

The CME trades commodities such as milk, butter, feeder cattle, cattle, pork
bellies, lumber, and lean hogs.15

NYMEX trades oil, natural gas, gold, silver, copper, aluminum, palladium,
platinum, heating oil, propane, and electricity. ICE Futures U.S. is where to look
for trades in coffee, cocoa, orange juice, sugar, and ethanol.161718

The London Metal Exchange and Tokyo Commodity Exchange are among the
most prominent international commodity exchanges.

Commodities are predominantly traded electronically; however, several U.S.

exchanges still use the open outcry method.

Commodity Market Requirements

In the U.S., the CFTC regulates commodity futures and options markets. The
CFTC is legally called on to promote competitive, efficient, and transparent
markets that protect consumers from fraud and other unscrupulous practices. This
is to help facilitate interstate commerce in commodities by regulating transactions
on commodity exchanges. For example, regulations set out to limit excessive
speculative short selling and eliminate the possibility of market and
price manipulation, such as cornering markets.

The law that established the CFTC has been updated several times since it was
created, most notably in the wake of the 2007-to-2008 financial crisis. The Dodd-
Frank Wall Street Reform and Consumer Protection Act gave the CFTC authority
over the swaps market, which was previously unregulated.19

The U.S. Department of Justice's Market Integrity and Major Frauds Unit uses data
analytics and traditional investigative techniques to uncover fraud, insider trading,
and schemes designed to artificially sway prices in the commodity markets. Since
2019, they've charged two dozen individuals at major banks and trading firms,
including JPMorgan Chase & Co. and Deutsche Bank AG, who admitted to
wrongdoing, with the companies paying over $1 billion in penalties.20

Commodity Market Trading vs. Stock Trading

Commodity Market Trading

 Traditionally more difficult for individual investors to access
 Focuses on physical assets, like precious metals, crops, or oil
 Supply of commodities can vary significantly based on the time of year,
demand, production levels, and other factors
 Doesn't pay dividends
 Potential for higher volatility

Stock Trading
 More accessible to individual investors
 Focuses on shares of ownership in businesses
 Supply of shares in an individual company are less variable, typically
changing only when new stock is issued or a buyback occurs
 May pay dividends
 May be less volatile

Wall Street is synonymous with images of stock tickers and bustling traders,
emblematic of company ownership stakes. At the same time, markets in
commodities can conjure everything from humble flea market-like stalls to traders
crying out to be heard on the floor of an exchange. For investors, it's important to
know the differences in what's traded on these exchanges. Here are some of the
essentials:

What's traded: The primary distinction between stock and commodities

exchanges lies in the nature of the assets. Stocks are fractional ownership in a
corporation, with their value closely aligned with the company's performance or
market sentiment about the firm. Commodities, meanwhile, are physical goods
with their investment appeal often hinging on supply and demand, weather
conditions, geopolitical developments, and industry changes.
Who's trading: Both markets draw institutional investors and hedge funds but
diverge in their other participants. The stock market is where companies seeking to
raise capital go, met by a diverse range of retail investors, often willing to do so.
The commodity market, by contrast, is for producers like farmers and mining
companies, processors, manufacturers, or other end-users (for example, airlines
that need fuel) who require a direct link to the tangible economy.

Returns and income: Stocks provide returns in two main ways: capital
appreciation (when the stock goes up) and dividends (periodic payments made
from the company's profits to shareholders). Commodities, however, don't have
dividends. Instead, commodity returns are primarily generated from profits made
from buying low and selling high. In addition, investors in commodity futures can
gain or lose from commodity futures contracts.

Risks involved: Both markets are fraught with risks. Corporate actions, economic
trends, and market sentiment often influence stock values. Commodity prices,
known for their volatility, can have dramatic shifts in light of geopolitical events,
weather, or excess speculation. Yet, commodities can effectively hedge against
inflation, potentially mitigating risks from a stock-heavy portfolio.

Trading methods: Stock trading is primarily electronic and centralized through

major exchanges like Nasdaq and the New York Stock Exchange. Commodity
trading, while now found on electronic platforms, still retains elements of
traditional physical trading (e.g., grain silos, freezer cars transporting meat)
alongside the complex world of futures and options contracts, which can be more
complex for investors.

Navigating the commodity markets requires a good understanding of supply chains

and global events, extending well beyond financial analyses, which can be
challenging enough. Individual investors may find trading commodity-focused
exchange-traded funds (ETFs) or shares in commodity-focused companies easier.

How Do I Find Out How the Commodity Markets Are Doing Today?

Many online financial platforms provide some indication of certain commodities

prices such as gold and crude oil. You can also find prices on the websites of the
commodity exchanges.

What Do Commodities Traders Do?

Commodities traders buy and sell either physical (spot) commodities or derivatives
contracts that use a physical commodity as its underlying. Depending on what type
of trader you are, you'll use this market for different purposes. For instance, you
might buy or sell a physical product, hedge parts of your portfolio, speculate on
changing commodity prices, or arbitrage across markets.

Are Commodities a Good Investment?

Like any investment, commodities can be a good investment, but there are risks.
To invest in commodities, an investor needs to understand the markets of the
commodity they wish to trade in. For example, oil prices can fluctuate based on the
political climate in the Middle East, so a trader should be well-versed in current
events as well as industry changes in light of climate change.

The type of investment also matters. ETFs provide more diversification and lower
risks, while futures are more speculative, and the risks are higher especially
when margin is used. That being said, commodities can be a hedge against
inflation.

The Bottom Line

Commodities markets are where tangible goods and contracts based on them are
traded. Commodities can be a way to diversify holdings, hedge against inflation,
and realize a profit, but traders should have a high tolerance for risk if they choose
this path.

As with other high-risk, high-reward trading opportunities, be sure you know and
understand the strategies behind trading commodities and their derivatives before
you add these assets to your portfolio.