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Commodity Trading

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Understanding Commodity Trading

Commodity TradingMany investors and traders shy away from commodity trading because they do not understand how the commodity markets and commodity trading works.  It is important to understand the basics of commodity markets and commodity trading prior to considering trading commodities.

A commodity can include a wide variety of raw materials such as gold or oil or agricultural products such as wheat or sugar, among many others that have a similar quality and are mass produced.  A commodity is a fungible item; meaning it can be replaced or exchanged by another identical product of similar quality that is produced anywhere.  The fungibility of commodities is what makes trading them possible, since interested parties can buy and sell the right to purchase a commodity knowing that they will be buying a product that is of similar quality no matter where it is produced.

Commodities are traded on a commodities exchange.  The leading commodities exchanges in the United States are:  Chicago Board of Trade (CBOT), Chicago Mercantile Exchange (CME), and New York Mercantile Exchange (NYMEX).

Commodities trade via contracts between buyers and sellers.  A commodities contract can consist of:  spot commodity prices, commodity forwards, commodity futures, and options on commodity futures.  A spot commodity price contract is what it costs to buy a commodity on a particular day at the spot (market) price.  Commodity forwards and commodity futures contracts are similar products since they are both agreements to physically deliver a set amount of a commodity at a specified future date; however, there are some distinctions between the two.  Commodities futures contracts are standardized contracts that trade via an exchange.  Commodities forwards contracts are customized by the seller and trade over the counter outside of an exchange.  Options on commodity futures trade as options based on the underlying value a commodity.  Commodities contracts allow producers of commodities to find buyers for their commodities at a market driven price based on supply and demand.

Commodity Trading Strategies

People trade commodities for a variety of reasons.  The strategy that a trader employs when engaging in commodity trading depends upon their reason for trading a specific commodity and their risk tolerance.

A company that produces a commodity might sell commodity futures contracts each month that reflect their monthly output of the commodity, so they can lock in their profits for the month and avoid future price fluctuations.  This commodity trading strategy could also be used by farmers that wish to lock in profits on the agricultural products that are produce on their farms.  Airlines could use commodities futures and options on commodity futures to hedge against spikes in jet fuel prices, so they can accurately estimate their fuel costs for the coming quarter or year.

Many traders and speculators use the variety of commodities contracts to speculate on anticipated price moves in commodities.  A trader buys a commodities contract to profit from an anticipated move higher in the price a commodity.  The higher the move above the target price (strike price) the commodities contract makes before the expiration date, the higher the profit is for the buyer of the futures contract.  Those who wish to profit from an anticipated move lower in the price a commodity can sell commodities contracts short.

Traders who buy and sell futures contracts that involve physical commodities like corn and oil are legally obligated to follow through with the contract requirements of a futures contract when the futures contract expires.  This means that if you sell a futures contract for 100 barrels of oil, you need to be prepared to actually physically deliver 100 barrels of oil to the buyer of that futures contract.  Due to this requirement, traders in commodities contracts do not typically hold their commodities contracts until the contracts expire, so they are not obliged to physically deliver the commodity.

Those who wish to trade commodities contracts are encouraged to learn as much as possible about commodity trading, which can be a very useful trading tool to take advantage of price moves in commodities.

To learn more about futures, see Buying and Selling Futures.  To learn more about options on commodity futures, see Option Trading Basics.

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