For those wondering, what is commodity trading, the shortest answer would be “it’s the buying and selling of raw material”. This of course is the short answer, but those interested in the longer and a more detailed answer, might want to read on.
For decades, commodity trading has been shadowed by stock trading. It just wasn’t quite making it in the financial arena. It just didn’t make as good a party conversation as the stock market did.
Few years ago this began to change. Of course there had always been a group of people that traded commodities, but they were rather few compared to the amount of individuals that have been trading the stock market the last twenty to thirty years.
What is commodity trading
So what is commodity trading? Is it something mystical or is this just another hype to lure honest people into financial ruin? Or could it be that this is a highly profitable venue for active traders?
For a detailed description you should read the basics of commodity trading, where we detail the origin of the commodity trading and describe the basic markets.
Before we continue with the discussion of what is commodity trading, we should take a look at how trading them is different from other things that are exchange traded, like stocks.
In its simplest form a commodity is a raw material or a product that can be used to produce something else, consume or exchange for another product or raw material. Commodity trading is therefore one of the few things that could be traded without using money.
The person trading commodities will always be buying physical items that he can expect to get delivered. This fact is one of the biggest difference between trading commodities and the various securities available. The physical value is always present in commodity trading while the value in stocks and other securities is more related to future expectation of financial growth.
Spot markets vs. futures markets
Until the 19th century, commodities were traded on what we call a spot market. Spot markets are markets where the actual commodity can be found and bought by payment of cash.
Some commodities are still mostly traded on spot markets, the typical fish market being an example of that. There the fish is sold by open outcry to the highest bidder who then takes instant delivery. Fruit markets fall into the same category.
For individuals interested in trading commodities, the spot market is not a practical thing to trade, unless the individual in question has a large warehouse that he can keep his investment or is planning to use it in the production of other items..
One of the biggest inconveniences with the spot market, is the fact that some commodities are seasonal, but the buyers interest and the sellers interest don’t always follow the same seasonal patterns.
As an example the farmer might want to sell his flour at a different time than the baker would like to buy it. The prices could also be different from the time the farmer went to the market until he had sold his product.
To facilitate a more efficient way for producers to sell their product and buyers to acquire it, a new type of market was developed. Through series of trials the commodity futures market came into being
The main difference between the spot market and the futures market, is the time of delivery. While the buyer on the spot market gets an instant delivery of the commodity he bought, the buyer on the futures market is buying a contract that promises a delivery of a certain commodity on a certain day.
The futures market also opened up the possibility for the buyer and seller to secure prices by buying or selling a futures contract that would be offset on the spot market, thus securing a price.
Another thing that was different in the futures market was the introduction of the “third man”, the speculator. With the introduction of the speculator, the markets became more liquid as he bridged the gap between the times when the traditional buyers and sellers would be interested to do their trading.
The speculator is different from the other two parties in the way that he’s not interested in delivering or getting a delivery of the product. His only interest is to profit from the price changes. Even though the speculator has somewhat a fragile reputation, his presence in the futures market is important to maintain the markets liquidity.
The traditional way of participating in the commodity futures market is a direct trading of futures contracts. Another way of participating in the commodity futures markets is through commodity options trading where the trader buys or sells an option where the underlying value is a futures contract in the specific commodity.
This article was written to give some insight into what is commodity trading. The subject is on the other hand to big to cover in one article so it is recommended that you read other articles on this site to get a fuller understanding of the commodities markets, how they work and how they can be traded.