Commodities Trading

Commodities Trading

Commodities are bought and sold through a variety of channels by a wide range of individuals and firms. Some of them are buying futures with the intention of taking delivery of the underlying assets for use in an ongoing business process. Others are buying and selling futures to reduce future price or cost uncertainty. Another group in the commodities market that is often maligned, but integral to the effective operation of the market is the speculators. Speculators assume the price risk from producers and consumers in the hope of making a return on the investment that is commensurate with the risk they are assuming. The investors in the commodities markets are very diverse and usually involved for a variety of different reasons.

The variety of types of commodities is limited in number compared to individual stocks and bond issuances currently on the market. They are typically divided into four major sections, energy, metals, agricultural, and livestock or meat. Energy is mainly crude oil and other petroleum sources. Metals include gold, silver, and platinum in fairly small volume know as the precious metals, as well as other metals such as steel and copper used in large quantities for manufacturing known as industrial metals. Agricultural focuses on cereal grains, as well as the oils produced from them. Livestock and meat are animals before and after processing for human consumption.

Commercials are the business entities that create the commodities and deliver them to market or take physical delivery of them. Securing price or cost is the main objective of commercials. Processing the commodity to change it into a product for profit is the core business of these firms. The futures markets help these firms know with certainty their future costs, so that they can calculate the return on investment to decide whether or not to invest in it. The companies use the commodities markets to protect themselves against a price move that would adversely affect business operations. This protection is called hedging.

Commercials and other investors use two types of hedges, long and short. What types of hedge they use depends on their inherent position based on the business they do. When a company buys a future contact in order to take delivery, it is considered to be in a long position. For example, if Kellogg bought a corn future contract with the intention of taking delivery of that corn for processing into cereal they would have a long position in corn. The need to have corn to continue business operations is an inherent short position. Kellogg's purchase of a long position balances the short position and offsets the chance of price increases. However, the farmer who grows the corn for sale has an inherent long position. The farmer needs to protect himself against the chance of future price decrease, so he will hedge his long position by using a short position.

The investors who provide balance to the markets by assuming the risk from commercial firms are the speculators. These speculators are divided into two groups, large and small. The large speculators are often groups of investors such as hedge funds or other pools of managed money. These types of funds are often run by a Certified Trading Advisor. Small speculators are individuals who trade at much lower volume on their own account or through a brokerage firm.

Commodities investors are divided into two groups necessary for the function of an efficient market. First the commercials, who need to hedge the risk of the inherent positions of their regular operations. Or else they would be forced out of business by price fluctuations of the underlying commodity. Second the speculators, who are needed to assume that risk from the commercials in the hopes of profit. Leverage allows smaller speculators to assume large risks equal to a portion of what a major multinational need to hedge against in the course of normal business.

Before the commodities markets were established, the prices of commodities were subject to a great deal of volatility. Most, if not all, of a crop would be ready for delivery to a customer at the same time. This oversupply led to a steep decline in the prices at one or two times a year. This steep decline caused many crop producers to lose money growing their crops and created a great deal of pricing uncertainty. It was obvious that many of these producers would have been profitable if they could have sold at the price the crop was when they planted it. In addition to the issues of pricing, it was difficult to transport and store the annual supply of the product all at once.

Futures contracts were the first instruments created to mitigate some of the price fluctuations cause by supply and demand. A buyer and a seller would agree to exchange the commodity for cash at a future point in time. The producer then would know how much he was going to be paid in the future, and the consumer could know his cost of material long before he needed to pay for it. These contracts varied drastically