Types Of Markets Part 9: Commodities Part 2

In the last segment we looked at what commodities are and how investors use them to diversify their portfolios. To quickly recap, commodities can be broken down to four major groups:

  • Metals
  • Energies
  • Livestock and Meat
  • Agricultural

These four categories have developed over the course of human progression as we have industrialised and streamlined the production of most raw materials.

That being said, commodities have been traded since the concept of exchange began. My chickens for your vegetables and so on. The trading of commodities is an ancient process with a history that is far further reaching than that of stocks and bonds and obviously the modern online trading systems that we have today.  In fact, the rise and fall of many empires and great nations can be causally linked and tracked to their ability to create these vast and complex systems to facilitate the trading of goods or commodities.

These days, commodities are still traded throughout the world – obviously. This exchange refers to both a physical location where people come together to buy and sell each other’s goods as well as legal entities that have been established in order to enforce the rules for the trading of standardized commodity contracts (which are like ownership contracts) and other related investment products such as government bonds and futures contracts.

Some examples of these exchanges include:

These are just some of the exchanges out there. Ranging from the US to the UK, you will notice that some of them have merged such as the CME and the NYMEX which better than others that have gone out of business completely. While the majority of exchanges trade multiple commodities, others specialize in a single group (such as the LME – as the name suggests).

So, how does one actually invest in commodities?

While there are many ways one can, right now we are going to focus on the most common way and that is futures.

First, let’s understand what a futures contract actually is. Essentially is it a legal contract or agreement between two parties that states one will sell a particular commodity asset at a predetermined price and the other will agree to buy that asset at that predetermined price at a specific time in the future. Hence the name, “futures contract”. What is happening here is that the buyer is taking on the obligation to buy and receive the underlying commodity asset once the contract expires while the seller is taking on the obligation to provide and deliver the asset, regardless of the market price of the asset. These contracts are generally available for every category of commodity

The reason why these contracts exist is due to the type of investor that would benefit from such a contract. Typically, you find two types of investor:

  • commercial or institutional users of the commodity
  • speculative investors

The first type would include manufacturers or service providers of large quantities of goods. They use these contracts as a budgeting tool to regulate or reduce fluctuation by agreeing to buy or sell at a set price. They take positions in the market to reduce the chance of making a loss due to price changes. This helps to keep expenses stable as well as to reduce potential cash flow issues.

How do you think companies such and McDonalds or large produce suppliers such as Clover or Enterprise are able to relatively keep their prices the same from year to year (not including inflation)? Or how airlines are able to keep their flight tickets relatively the same? In order to secure large amounts of fuel at stable prices (regardless of supply and demand) they engage in hedging with multiple futures contracts so that over a long period of time, they can acquire fuel and roughly similar prices an avoid all in interim volatility in the market. The food industry does the same thing to keep their prices predictable and stable to manage their operating expenses. That is why the key to running a restaurant is to manage your overheads and securing deals with your suppliers – basically you are trading a kind of futures contract in saying, “I will buy X amount of bread from you over a period of X amount of months if you can agree to give it to me at this price for the duration of the contract”

Then you get speculative investors. This is what most of us would be, investors (or traders) who would buy a commodities asset and hold it for a short period of time and use certain strategies to benefit from the change in price. These investors make money as certain futures contracts become more or less desirable and therefore the buy into the contracts fluctuates. They are called “Speculators” because they never actually handle the actual goods that they are speculating on. They close out their position on the contract before it is due and therefore never actually take possession of the goods.

In order to trade futures contracts in this way, you will need a broker that allows it to be done. The broker that we trade with here, Blackstone Futures, is one such broker. Often, futures contracts will require a different minimum deposit depending on the broker, and the value of your account will increase or decrease with the value of the contract – very much like basic CFD Trading. If the value of the contract decreases, you may be subject to a margin call and required to deposit more money into your account in order to keep the position open – however, that is where risk management in any sort of investment/trade becomes so important. Due to the high level of leverage, small price movements in commodities can result in either large returns or large losses; a futures account can be wiped out or doubled in a matter of minutes. Luckily, Blackstone Futures has their leverage at a 1:500 ratio so that you have a good balance between being able to make good money while not over exposing yourself to the market.

Futures are just the tip of the iceberg of trading commodities. Next week, we are going to be diving even deeper into this complex and broad type of market.

Until next time, Happy Trading.

Samuel Commons – Trader.

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