101-13 What are Commodities Markets and How Do They Work?

A commodity market is a market where goods and services are traded. The law of supply and demand determines the prices of these goods and services. In a commodity market, buyers and sellers meet to trade goods or services at a mutually agreeable price.

The term “commodity market” can refer to physical markets, such as the New York Stock Exchange, where commodities are traded, or virtual markets, such as the Chicago Mercantile Exchange, where futures contracts for commodities are traded. Commodities can be either physical goods, such as corn or oil, or intangible goods, such as natural gas or electricity.

Course 101: Introduction to Investing
What are commodities markets, and how do they work?

Commodity Prices

The prices of commodities are affected by many factors, including weather, politics, and the state of the economy. For example, a drought in the Midwest can cause the price of corn to rise because there is less corn available to be traded. Similarly, if there is political instability in a country where oil is produced, oil prices may rise because less oil is available to be traded.

Commodity Hedging

Many investors trade commodities as a way to hedge against other investments. For example, if an investor owns stock in a company that produces corn, and the price of corn rises, the stock’s value may also rise. Conversely, if the price of corn falls, the stock’s value may also fall. By hedging their investments, investors can protect themselves from losses if the prices of commodities fluctuate.

Commodities Volatility

Commodity markets can be volatile, and prices can fluctuate rapidly. For this reason, investors need to do their research before investing in commodities. They should also be aware of the risks involved in commodity trading.

This section takes a look at commodities and precious metals, the physical goods that form the building blocks of the products we use and the food we eat.

Traditional Commodities

Commodities were traditionally physical goods or raw materials such as sugar, maize, barley, pork bellies, milk, cocoa, cotton, gold, silver, or copper. However, the commodities exchanges have expanded to encompass more everyday items such as energy and even computer RAM chips.

In the commodities market, there are different types of transactions.

Spot Trading

The participants in a commodities spot trade usually expect immediate or near future delivery of the actual goods they have purchased. This is a way for the corn farmer to find a buyer for his corn on the open market. Because of the short delivery time, spot trading will usually take place in a wholesale market and allow the buyer to inspect the goods.

Forward Contracts

A forward contract is the agreement to exchange the goods at a specified time in the future for a price agreed upon today. This protects the corn farmer from falling prices and the corn oil producer from rising prices. This minimizes the risk for both parties of doing business.

Futures Contracts

As discussed earlier in the futures section, commodities can be traded as futures contracts meaning that the buyer and seller of the contract do not necessarily expect to receive delivery of the products they have purchased; they simply accept the cash equivalent.

In the U.S., the regulating body for the commodities exchanges is called the Commodities Futures Trading Commission.

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