Commodities are actual physical goods such as grain, gas, metals, cattle, and food products. The commodity market consists of exchanges where commodities are bought and sold using standardized contracts. There are currently 48 large commodity exchanges world-wide selling approximately 100 different commodities. Eurex, an electronic exchange in Europe, is the world’s largest commodity market.
The existence of commodity contracts and exchanges appears to date back to the ancient civilization of Sumer. The primary products traded at that time were grain and livestock. There are now five basic categories of goods sold on the commodity market; grains, such as corn, wheat and soybeans; energy products, including crude oil, heating oil, gasoline and natural gas; metals, such as gold, silver and copper; softs, a category that includes food and manufacturing products such as cotton and coffee; and livestock.
In order for a product to qualify for trade in the commodity market, it must meet certain guidelines. In the case of industrial and agricultural products, the commodity must be in its raw form. For example, corn is acceptable, while cornmeal is not. Perishable commodities, like frozen orange juice, must have an adequate shelf life.
Commodity market exchanges are set up in the same way their stock counterparts. Exchange floors are divided into sections, called pits, where traders stand facing each other. Each section is dedicated to a particular commodity. Traders on the floor must be members of the exchange. Non-members, such as farmers or investors, must work through a brokerage firm which holds a membership in one of the exchanges.
The commodity market is used as a hedge against fluctuating prices. One example of a commodity transaction is a cotton grower who wished to negotiate a firm price for his crop prior to harvest, when excessive supplies may result in a glut on the market. A futures contract on his harvest can be also used by the grower as collateral for loans. The manufacturer purchasing the cotton benefits by knowing his costs in advance. He is also protected against the possibility that costs may raise drastically due to adverse crop conditions.
The commodity market is made up of two primary types of buyers; those with a legitimate need to sell their goods or purchase commodity products for future use, and those who wish to speculate in commodity contracts to make a profit. Most commodity products are sold through futures contracts which guarantee that a certain quantity of a commodity will be sold at a future date for a predetermined price. Contracts for immediately deliveries are called spot contracts, and are often used to fill a futures contract.
Investors who speculate in the commodity market buy and sell futures contracts with no intention of every taking possession of the underlying product. If the commodity price goes up, the contract becomes more valuable; if the price drops, so does the contract value. The contracts are frequently liquidated prior to the delivery date.
Some advantages of investing in commodities include lower commissions, and a quicker turnaround on the investment. These markets are very fluid, and prices fluctuate much faster than in real estate or stocks. Also, traders can use a margin account with a lower percentage of cash up front than with stock margin accounts. While the opportunity for a quick profit is present, so is the possibility of a quick loss. Investors should spend adequate time studying the commodity they wish to trade in prior to making a significant investment.