What is a Commodity

To understand the somewhat complex and dynamic commodity futures markets, I should start first by answering the fundamental question of what is a commodity in the context of the futures markets, and why we refer to this market as futures.

 

A cash commodity is an actual physical commodity that could be bought and sold. It may consist of a raw material or an agrucultural product – such as wheat, corn, cattle, gold, petroleum, etc. – or could be a financial instrument (such as  U.S. Treasury bonds, notes, bills, derivatives, stock index) etc.

A futures contract is an obligation to buy or sell a specific quantity of a cash commodity for a fixed price agreed upon today and to be delivered at a particular date in the future. In other words, the futures contract is based on a specific cash commodity for delivery at a stipulated future date. 

The futures market exchanges where these contracts are made have been described as clearing houses and continuous auction houses for the latest information about supply and demand. They are the places where buyers and sellers connect and trade anything from agricultural products to financial instruments. 

The idea is that when you agree to buy a commodity futures contract, you're essentially agreeing to buy something for a set price that a seller has not yet produced or delivered. But as you will see, simply because you're participating in the futures market doesn't mean that you will be responsible for receiving or delivering large inventories of physical commodities.

To the novice, the feverish activity on the trading floor of a commodity futures exchange market, with all the frantic shouting and signaling of bids and offers, might suggest a chaotic environment. The reality, however, is that chaos is precisely what the commodity futures markets replaced.

Since the mid-nineteen century, the commodity futures markets have served a vital economic function: provide an effective mechanism for the management of price risk. It makes it possible for those who want to manage price risk (the hedgers) to transfer some or all of the risk to those who are willing to accept it (the speculators)

Prior to the establishment of central grain markets in the mid-nineteen century, farmers carted their newly harvested crops each fall over bumpy roads, in search of buyers in the major population centers. The excess supply drove prices to giveaway levels. In addition, lack of proper storage caused grains to rot.

Come spring, shortages would frequently develop and foods made of commodities, such as corn and wheat, became luxuries. Clearly, a mechanism for organized and competitive bidding was necessary. When the first central markets were formed to meet this need, contracts were entered as for spot (immediate) delivery. Eventually, contracts were entered for forward delivery. These so-called forwards were the forerunners of present day futures contracts.

Whether it's a farmer from Kansas, an importer from Hong Kong, or a speculator from Buenos Aires, all have instant access to the markets, and all have the ability to participate in the market by having their broker buy or sell futures contracts.   

 

The Commodity Futures Market Participants

A primary function of futures markets is hedging.

Hedgers are companies or individuals who own or are planning on owning a cash commodity, and are concerned that the cost of the commodity may change before they either buy or sell it. Individuals or entities that use the futures markets for hedging are: farmers, grain elevator operators, bankers, exporters, manufacturers, insurance companies, pension fund managers, portfolio managers, and others.

For example, a soybean processor enters an agreement to sell soybean oil to a food manufacturer. Both agree on a price today even though the oil will not be delivered for six months. Since the soybean processor does not own the actual soybeans that he will use eventually to process into oil, he is concerned that soybean prices may rise during the next six months, causing him to lose money.

To hedge against the risk of rising soybean prices, the soybean processor buys soybean futures contracts calling (at today's prices) for delivery in six months. When five and a half months have passed, the soybean processor purchases the actual soybeans in the cash market (the place where people buy and sell the physical commodities). But suppose that just as he had feared, the prices of soybeans had gone up. Well, no problem. Because he hedged in the futures market, the soybean processor can now sell his futures contracts and use the gain to offset the higher cost of soybeans.

(The reason he can sell his futures contracts, is because as you'll learn ahead, commodities trading is a zero sum game. In other words, for every existing buy contract  there is an equivalent sell contract.. If you're holding the buy contract you have to buy, if you're holding the sell contract you have to sell. So at the end of the day somebody makes money and somebody loses).

Generally, cash and futures prices tend to move in a parallel pattern, since they react to the same factors of supply and demand.

 

Speculators - such as you and me – are traders that trade in the futures markets hoping to profit from price fluctuations. People that speculate play a critical role in the futures markets by providing liquidity and capital, helping to ensure price stability.

Speculators enter the commodity futures market by either buying or selling a futures contract. As opposed to the example above with the soybeans processor, a speculator rarely would have an interest in owning the physical commodity or financial instrument that underlies a futures contract.  As for the speculator's decision to enter the market by either buying or selling first, it will depend strickly on on each person’s market expectations.

For example, you may believe that the price of oats will be going up. Thereby, you purchase one CBOT futures oats contract calling for you to take delivery of 5,000 bushels of oats on a specific day in May.  This is known as taking a long position. Theoretically, it "be-longs" to you. But since you have no intention of having 5,000 bushels of oats delivered to your door step, some time before the contract expiration date you are going to sell this futures contract (hopefully at a profit). In other words, you are going to offset your position.  

  Initial Position:           Buy one May oats CBOT contract at $2.00/bu
 
Offsetting Position:     Sell one May oats CBOT contract at $2.50/bu
  Net Profit (Loss) =      $2,500 ( 5,000 bushels times $0.50)
    
The delivery month is important. Oats, for instance, is delivered in December, March, May, July and September. So if you bought oats that calls to be taken delivery in May, you must sell oats to be delivered in May to offset your position.

If, for instance, you are long three May CBOT oats contracts and you wanted to offset your position, you would sell three May CBOT oats contracts. In effect, all the specifications must be the same: the commodity, number of contracts, exchange and delivery month. One contract negates the other.

In the same manner, you may believe that the price of corn will be declining in the future. Therefore, you enter the market by selling a CBOT corn futures contract, in the hope of later being able to buy back identical and offsetting contracts at a lower price. In this case you are shorting the market. You're going short on corn.

Initial Position:          Sell one July corn CBOT contract at $3.00/bu
Offsetting Position:   Buy one July corn CBOT contract at $2.60/bu
Net Profit (Loss) =     $2,000 ( 5,000 bushels times $0.40)

Even though approximately 97% of traders never deliver or take delivery of the commodity they trade, the delivery provision in a futures contract is important. Because just the fact that buyers and sellers can take delivery if they chose to, assures that futures prices accurately reflect the cash market value of the commodity at the time the contract expires.    

In essence, if you are long a commodity you want it to increase in value. If you are short the commodity, you anticipate it declining in value. The commodity market is a zero-based market. At the end of each day the books are balanced. The traders on the losing side of the market pay the traders on the winning side of the market.    

 

Trading Styles       

Three basic trading styles:
    
    The
Scalper, who trades in and out of the market many times throughout the day in hopes of taking small profits on heavy volume of trading. He rarely holds a position overnight. Most floor traders are scalpers.
    
    The
Day Trader, who is similar to the scalper in that he doesn't hold overnight positions. However, he makes fewer trades and hopes to profit from intraday trends.
    
    The
Position Trader, maintains a position for days, weeks or even months. The position trader is more focused on major long-term price trends.

 

Go to futures markets terminology to continue tutorial.