How Does the Commodities Market Work?

What Is a Commodity Market?

Similar to any other market around the world, the commodity market allows participants to buy or sell products that range from luxuries to everyday essentials. Many commodity centers exist around the world, facilitating trade between suppliers, manufacturers, speculators, and others.

Commodities are usually separated into two groups: Soft and hard commodities.

Soft commodities are mostly agricultural and are grown and harvested. They include popular and mainstream ones such as corn, wheat, sugar, soybeans. Another type of soft commodity includes livestock like pork and hogs. On the other hand, hard commodities are natural resources that are extracted from the earth and include gold, oil, natural gas, and copper.

Commodities can be broken down further into multiple categories in the following manner: (Figure 1)

Metals: Gold, Silver, Platinum, and others.
Energy: Crude Oil, Heating Oil, Natural Gas among others.
Agriculture: Cocoa, Coffee, Cotton, Sugar, and others.
Livestock and Meat: Hogs, Pork Bellies, and others.

Figure 1 - 2-Hour Chart of Gold, Crude Oil and Coffee
Please click For bigger size

How Commodity Markets Work

The commodity market allows a wide range of market participants to gain access to a centralized and liquid location that includes around 100 major products. Participants include outright suppliers and producers, focusing on obtaining or simply selling the commodity while others may be looking at it as a way to hedge against a certain exposure in the same product or another. Speculators and investors are also present in the commodities market, betting on a rise or fall in prices while others may hold commodities to protect their portfolio against adverse market conditions.

Certain commodities may act as a hedge against certain uncertainties such as inflationary expectations while a group or basket of commodities can also be useful in times of volatility given their tendency to move opposite of stocks.

Commodities prices are affected by a variety of factors that are fairly common across all other markets including supply & demand, Geopolitical tension, Central bank and interest rate decisions, Economic conditions, and many more. Specifically, for commodities, the supply & demand element is strong as many of the traded commodities are seasonal or affected by factors that could lead to disruptions of supply or demand.

Brief History of Commodity Markets

Historically, commodities date back thousands of years when tribes and older civilizations traded different products against each other including commodities, food, and other items. Technically speaking, it was the only way to pay for essentials and this practice continued into more recent history until currencies became a means to transact.

Trading in commodities was not available to everyone and required large sums of money, time, and the necessary expertise to be a market participant. With the advent of technology, trading commodities is something available for access to nearly all traders and investors and with plenty of ease.

One of the oldest and most popular exchanges is the Chicago Board of Trade. The CBOT started in 1848 and allowed for trading on agricultural commodities such as wheat and corn. This helped farmers and consumers manage risk by eliminating uncertainty in prices from the traded products. Today, the CBOT is one of the biggest in the world, offering options and futures on a wide range of products including commodities, interest rates, and equity indices.

Types of Commodity Markets

Commodities are available for trading in the spot markets or derivatives markets. The spot markets are known as physical or cash markets where buyers and sellers exchange commodities for instant delivery. On the other hand, the derivatives markets are made up of forwards, futures and options.

Forwards and futures are contracts that use the spot market as the underlying asset. Such products give the buyer control over the commodity in the future for a price decided up today. Given the speculative nature of online trading, most contracts are closed before expiry or rolled over as traders are not interested in taking delivery.

The main differences between the two are that futures are standardized and trade through an exchange while forwards are customizable and trade over the counter.
Trading commodities, similar to trading any other product is no longer a hassle thanks to online applications and quick deposit methods which could see traders up and connected to major financial centers in minutes.

Traders can trade commodities outright through the spot market or by trading the derivatives but they can also gain exposure to commodities through the stock market. For example, the stocks of mining companies fluctuate with the price movements of the actual commodities and could be used as a hedge or another form of exposure to certain products. ETFs, also known as Exchange Traded Funds can be commodities specific, investing in a basket of products, or can be centered around one commodity, thus, creating direct exposure to it.
For those who trade stocks exclusively, gaining exposure to commodities through stocks or ETFs is easier to manage than using derivatives such as futures and options.

Examples of Commodities Markets

There are dozens of commodities exchanges around the world but the majority are found in the US and more specifically, Chicago and New York. The Chicago Board of Trade is among the oldest and was established in 1848. The Chicago Mercantile Exchange trades a variety of commodities including cattle, lumber, lean hogs, and others.

In New York, the New York Board of Trade allows trading on Coffee, Cocoa, Orange Juice, Ethanol, and many more while the New York Mercantile Exchange provides trading on Oil, Gold, Silver, Platinum, (Figure 2), Electricity, and others.

Other centers include Kansas with the presence of the Kansas Board of Trade and Minneapolis where the Minneapolis Grain Exchange is found. Across the world, the London Metal Exchange is a major one across Europe while the Tokyo Commodity Exchange is fairly known across Asia.

While most exchanges and commodities trading, in general, takes place online and electronically, some exchanges still include a pit where the open outcry method is employed.

Figure 2 - 1-hour platinum char
Please click For bigger size

Commodity Market Regulation

The “CFTC” also known as the “Commodity Futures Trading Commission” regulates futures and options trading on commodities. It helps protect traders from fraud and misleading practices while promoting an efficient and transparent market. Other market centers are regulated by their respective jurisdictions but the CFTC is among the most popular ones as it regulates the top commodity exchanges across the US and which happens to be among the biggest in the world.

Commodity Market Trading vs. Stock Trading

In terms of similarities, whether you are trading stocks or commodities, they are both oriented towards Similar goals including making a profit or protecting against certain exposure. There are thousands of tradable stocks around the world, giving traders the ability to diversify further and have access to more opportunities while tradable commodities are nowhere near as numerous as stocks.

From a hedging perspective, commodities may prove very useful for those holding already established portfolios and looking to protect against potential downside brought upon by company, sector, or economic reasons. This is because commodities have historically moved opposite to stocks.

Whether it’s stocks or commodities, the market players are mostly similar and trading takes place electronically and throughout a large part of every day, 5 days per week.
Stocks may prove easier to buy and hold as their bouts of volatility are more limited and successful companies tend to grow with time, leading to higher prices through increased demand. On the other hand, commodities are prone to volatility and supply/demand disruption which could create powerful price swings over short periods.