A commodity is a raw material that is used in the production of goods or services. It is a basic good that is interchangeable with other goods of the same type, and is usually in its unprocessed or preliminary stage. Examples of commodities include agricultural products like wheat, corn, and soybeans, metals such as gold and copper, and energy resources like oil and natural gas.
The quality of a given commodity may differ slightly, but it is essentially uniform across producers. When commodities are traded on an exchange, they must meet specified minimum standards, known as a basis grade. This ensures that the commodity is of a certain quality and can be used in the production of finished goods or services.
Commodities play an important role in the global economy, as they are essential inputs in the production of a wide range of goods and services. For example, crude oil is used to produce gasoline for vehicles, while wheat is used to produce flour for baking bread. The prices of commodities can fluctuate based on supply and demand, as well as external factors such as natural disasters and geopolitical events. As such, the price of commodities can be an indicator of overall economic conditions, and can affect a wide range of industries, from farming to energy production to manufacturing.
However, commodities are not just physical goods that are used in the production of other goods and services; they are also financial assets that can be traded on specialized exchanges. In addition, there are sophisticated financial instruments known as derivatives, such as forwards, futures, and options, which are based on the value of these commodities. Many investment experts suggest that a well-diversified portfolio should include commodities to some extent, since their value is not closely tied to that of other financial assets, and they can provide a hedge against inflation.
For example, let’s consider gold, which is a popular commodity. In addition to being used in jewelry and electronics, gold is also considered a safe haven asset during times of economic uncertainty. This is because the value of gold is not closely tied to the value of other financial assets, such as stocks and bonds, which may be negatively impacted by economic turmoil. During times of high inflation, the price of gold may increase as people turn to it as a store of value. As such, investing in gold, either directly or through derivatives, may help to diversify a portfolio and provide a hedge against inflation.
Producing, buying and selling commodities
Commodities are commonly bought and sold through futures contracts on exchanges. A futures contract is an agreement between two parties to buy or sell a particular asset, such as a commodity or a financial instrument, at a predetermined price and date in the future. The price of the asset on the future date is set in the contract, and both parties are obligated to fulfill the terms of the contract when it expires.
Futures contracts allow buyers and sellers to lock in a price for a commodity, so they can protect themselves from price volatility in the market. For example, a wheat farmer can sell wheat futures contracts to lock in a price for the wheat they will harvest in the future. This way, the farmer can protect themselves from the risk of the wheat price dropping before the harvest.
On the other hand, buyers of futures contracts, such as a cereal manufacturer, can buy futures contracts to lock in the price of the wheat they will need to purchase for their business in the future. This way, they can protect themselves from the risk of the wheat price increasing before they need to buy it.
Futures contracts are traded on exchanges, and they can be bought and sold by traders who are speculating on the future direction of the price of the underlying asset. However, for most beginners, it’s important to focus on the use of futures contracts as a tool for hedging risk, rather than as a speculative investment.
These futures contracts establish a standardized quantity and minimum quality of the commodity being traded, ensuring that both buyers and sellers are on the same page when it comes to the terms of the agreement.
In essence, there are two types of traders involved in commodity futures trading: buyers and producers. These traders use commodity futures contracts for hedging purposes as discussed above. Producers, such as a wheat farmer, use futures contracts to hedge against the risk of losing money if the price of wheat falls before the crop is harvested. By selling wheat futures contracts when the crop is planted, the farmer can guarantee a predetermined price for the wheat at the time of harvest.
Buyers, such as a bakery that needs wheat to make bread, can use futures contracts to hedge against the risk of paying a higher price for the commodity in the future. By buying wheat futures contracts at a predetermined price, the bakery can protect itself against the possibility of price increases.
In both cases, the futures contracts enable the participants to reduce their risk exposure and lock in a price, providing a level of certainty that is crucial in the highly volatile world of commodities trading.