What is the Commodity Market?

What is the Commodity Market?

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Simply defined, the commodity market is a marketplace where raw materials or primary products can be bought and sold. Commodities can be divided into two main categories, namely hard and soft commodities.

Hard commodities are natural resources that must be extracted or mined from the earth, including gold, rubber, and oil. Soft commodities are agricultural products or livestock, including corn, wheat, coffee, sugar, soybeans, pork, cattle, beef, poultry, and so on.

How does the Commodity Market Work?

The commodity markets allow both producers and consumers access to commodity products in a liquid and centralized marketplace. These market participants can use commodity derivatives to hedge future production as well as consumption.

Many market participants are spectators, investors, and arbitrageurs who have an active role in commodity markets. 

There are many commodities, such as precious metals, which have been thought to be a good hedge against inflation, such as silver and gold, while there are a broad set of commodities that are placed in an alternative asset class and that help to diversify the investment portfolio.

Commodity prices tend to move in opposition to stocks, and many investors rely on them when there are periods of volatile market conditions. In the past, the trading of commodities used to be time-consuming, required a specific level of expertise, and used to be limited to professional and institutional traders. 

However, today, there are more flexible options for participation in commodity markets for retail traders and retail investors.

The trading of commodities is typically based on supply and demand, with prices that fluctuate according to these two factors. If demand for a commodity product is high and there is less supply, the price will increase.

In reverse, when there is a high supply of a certain commodity and the demand is low, the price will decrease.

History of Commodity Markets

Commodity trading traces its origins to the beginning of human civilization between 4500 and 4000 BCE, to what was known as Sumer, which is in modern-day Iraq. In Sumer, citizens used clay tokens which were sealed in clay vessels as a medium of exchange for goats.

There were clay writing tablets that recorded the number of clay tokens inside each vessel, and the merchant would deliver the right number of goats based on the number of tokens. Clay tablets in those days indicated the number of tokens, the time and date of the transaction, and this indicates that it was the earliest form of commodity futures contracts.

There were other civilizations where there are similar examples where pigs, seashells, and many other common items were used as “commodity money,” and over many centuries, traders improved the system, eventually resulting in silver and gold trading markets in more classical civilizations.

The earliest commodities traded may have been goats and pigs, but when these classical civilizations emerged, people started using gold and silver as a medium of exchange instead. These metals may be taken for granted today, but they used to have significant value as cash throughout most of human history.

In earlier civilizations, silver and gold were valued for their beauty and not their cash value, attracting the attention of royalty, which led to these metals being associated with royalty and led to silver and gold having intrinsic worth.

With the centuries passing, silver and gold naturally evolved into a medium of exchange on their own as the supply of these metals increased. Gold became a prominent medium of exchange as it could easily be melted, shaped, and measured, marking it as one of the first forms of commodity trading in history.

The commodity markets grew rapidly in medieval Europe, and at the time, commodity markets were the best way to distribute labor, land, goods, and capital across the region. Merchants would eagerly accept gold in exchange for goods as they could use gold throughout most of the world.

In the 1500s, with the emergence of stock exchanges, commodity markets grew and evolved.

The first stock exchange in the world was the Amsterdam Stock Exchange that emerged in 1530, operating as a market where commodities could be exchanged. During the 1500s and 1600s, the number of cities that added their exchanges for commodities increased, allowing for more diversity across the world.

The United States of America entered the commodity trading scene in 1864 with the establishment of the Chicago Board of Trade (CBOT), which used wheat, corn, cattle, and pig as standard instruments.

During the 1930s, the CBOT expanded commodity trading with the establishment of the Commodity Exchange Act, which added new items such as rice, mill feeds, butter, eggs, soybeans, and potatoes.

In 1934, the United States government created the Commodity Price Index, which tracked 22 sensitive basic commodities whose markets were the first that were influenced because of economic changes.

In 1940 the Commodity Price Index became available to the public, and it consisted of 22 commodity prices. And eventually, most countries around the world would have their version of this price index.

At the start of the 1990s, the Commodity Index Fund became available, a fund where assets that are invested into financial markets are based on a commodity index. Some of the largest commodity index funds today include Oppenheimer, S&P GSCI Commodity Index Fund, and several others.

Over the 20th century, there were commodity exchanges that emerged across America, including St. Louis, Kansas City, San Francisco, and several others. However, Chicago continued to be the hub of commodities future trading throughout the US.

With the advent and widespread adoption of the internet in the 21st century, online trading systems have led to a heightened interest in the trading of commodities and futures. Today, traders and investors follow professional careers in trading, with markets having expanded to address the significant growth experienced.

The Chicago Mercantile Exchange (CME) remains the largest exchange for commodities in the world, even if there are futures and commodities markets across the world.

Advantages of the Commodity Markets

  • Protection against inflation
  • Hedge against geopolitical events
  • High leverage
  • Diversification
  • Transparency

In terms of protection against inflation, with the rise in demand for both goods and services, there are increases in the price of these goods and services, with the cost of raw materials increases as well.

Where there is such an inflationary environment, interest rates are set to rise, and this will increase the cost involved with borrowing, reducing the net income of many people and companies. A decline in income will affect the profits that are shared with shareholders.

Where the prices of stocks will inevitably drop with inflation, the prices on commodities will rise because of growing demand, ensuring that traders, companies, and investors are protected.

In terms of being a hedge against geopolitical events, commodities can help to stem losses in many investment portfolios. There are many geopolitical events such as riots, wars, and unrest that can influence the supply chain, resulting in a scarcity of resources.

This makes it difficult to produce and transport raw materials to factories where they can be transformed into finished products. 

This means that the supply of raw materials can be affected, causing commodity prices to rise exponentially and causing stock prices to plummet, with investment in commodities there to offset these losses.

In terms of high leverage facility, commodity derivatives provide a high level of leverage that can be used. This allows investors and traders to control a large position by paying between 1% to 10% of the overall contract value as upfront margin.

In terms of diversification, commodities are known to have negative to low correlation with stocks as they are raw materials that are needed to make finished products. With the rise in commodity prices, the cost of production will be increased, reducing profits, and leaving little for shareholders as the earnings per share are decreased.

There is also inflation to consider, with the present values of future cash flows that are paid by stocks declining as future cash cannot purchase as many goods or services as it can today.

However, because of this correlation, where the prices of commodities can drive stocks down, the losses incurred in stocks can be adjusted against the gains that are attained by investing in commodity derivatives.

This means that investors who invest in commodity markets as an extended part of their portfolio can provide diversification and ensure that there is balance and that losses are offset.

In terms of transparency, commodities are traded through electronic trading platforms that are accessible to all types of market participants. Electronic trading platforms ensure that there is fair price discovery driven by board-scale participation, lowering the intervention of the buyer and seller.

The prices are determined solely by supply and demand, and this eliminates any form of manipulation.

Disadvantages of the Commodity Markets

  • Leverage 
  • Volatility
  • Not ideal for diversification
  • Lower returns and higher volatility
  • Asset concentration

While leverage is a great advantage, it is also considered a disadvantage as it can lead to significant losses when traders and investors open large positions and the market turns against them.

In terms of volatility, commodity prices are highly volatile, and they depend heavily on supply and demand factors, with supply and demand on commodities considered to be price inelastic.

Price inelasticity simply means that while prices either increase or decrease, the supply of a commodity will remain unchanged. Commodities are also prerequisites for daily operations, and price changes will not affect their demand as they are considered essential.

In terms of commodities not being ideal for diversification relates the negative or low correlation between commodity prices and stock prices. There are occasions when the price of commodities can fall in line with that of stocks, meaning that commodities are not always successful for diversification.

There are some factors such as unemployment and reduced demand that can halt production, leading to lower energy consumption, the unavailability of cash of financial purchases, and so on that can impact commodities to diversify the portfolio of an investor.

In terms of commodities yielding lower returns with higher volatility, the returns that traders and investors see with commodities are far lower than the volatility percentage and risk that they face in trading commodities. It is, therefore, a very risky field for long-term, buy-and-hold investors.

In terms of asset concentration, diversification may be one of the main reasons for investors to include commodities in their portfolio, but the commodity funds are concentrated in either one or two industries which leads to non-diversification.

What Are The Examples of Commodities?

The examples of different commodities are as follows:

  • Metals – which include silver, platinum, and gold.
  • Energies – which include crude oil, heating oil, gasoline, and natural gas.
  • Agriculture – which includes corn, beans, wheat, rice, soybeans, and any other agricultural products.
  • Livestock and Meat – which includes pigs, chickens, cattle, eggs, beef, mutton, and so on.
  • Industrial Metals – Aluminium, steel, copper.
  • Financial (Equities) – US Treasury Bond futures, US Treasury bill futures, indexes, and currencies.
  • Soft Commodities such as sugar, coffee, cocoa, and cotton.
  • Pulp such as lumber.

Are Commodity Markets Good for Beginners?

No, commodity markets are not good for beginners who are just starting in trading and who have no prior experience, knowledge, or skill in trading.

While the commodity market has many advantages for investors and traders, there are significant risks involved in trading commodities because prices are dependent on supply and demand, which are influenced by many factors, such as geopolitical events that can occur at any moment.

Beginners who want to trade in commodity markets are advised to first gain experience in trading by using educational materials alongside demo accounts to learn how to trade. This also involves developing a solid trading plan, using the right trading style and trading strategies to trade in commodity markets.

What is the Difference Between the Commodity Market and the Stock Trading?

Both stocks and commodities are two of the most widely traded financial instruments today. Both these asset classes serve as one of the most powerful influences on the global economy along with business infrastructure and the trading behaviors of millions of retail traders and investors alongside institutional participants around the world.

While there are some things that these two asset classes have in common, the following factors set them apart.

  • Ownership of the asset
  • Duration of trade
  • Fundamental drivers
  • Trading hours
  • Bid-Ask spread

In terms of asset ownership, those who invest in stocks effectively take ownership of the asset, which is a share of the company, unless they are trading a derivative. However, when trading derivative commodities, traders do not own the asset but only the contract that represents it.

In terms of duration of trade, stocks can be traded either over a short timeframe or invested in over the long term. Commodities are often day traded, swing traded, or scalped as their price depends on some fundamental drivers.

In terms of fundamental drivers, both stocks and commodities can be influenced by the same fundamental drivers. However, the main driver for commodities remains supply and demand, while the main driver for stocks is the financials of the businesses that are involved, namely earnings and dividends.

In terms of trading hours, the closing times for stock markets vary while the commodities markets are open around the clock.

In terms of the bid-ask spread, the spread for stocks is usually lower because stocks can change hands quickly, whereas there are higher spreads with many commodities because of the high trading volume.