Commodities

A commodity is a basic good or product that must be essentially identical regardless of who made it, meaning that no matter where you buy the good, it is basically the same. Commodities are often used as a material in the production of other goods and services and, when traded on exchanges, must meet minimum standards known as a basis grade.

 

The ruling principle of a commodity is that the good itself is identical to the same good being sold by another party in another location. This is different than a car that may have different features depending on where you buy it or who produces it. 

                Commodities generally are the base line products of a given economy. As stated on investopedia.com, they are typically used as inputs in the production of other products or services and are therefore a staple in most economies. The sale and purchase of commodities futures contracts most often takes place on a futures exchange used in order to hedge the risk of price variances for the commodity producer/distributor. Because every industry relies on at least one commodity to function, the futures market is a leading indicator for stock market performance.

                Take, for example, crude oil. If the price of crude oil goes up it affects almost every industry, it especially impacts industries that consume large amounts of fuel, like companies that specialize in shipping or travel. When the price of oil increases, the impact is felt almost immediately at the gas pump. For a company in the package delivery industry, that translates into higher shipping costs because it costs more money to get a truck from one side of the country to the other. The increased cost lowers the profitability of each shipment. That decrease in profit will be reflected in the price of the company’s stock.

                Commodities traded with futures contracts are subject to the same rules and specifications of all futures contracts. In a futures contract there is a spot or call month dictated in the contract. According to investopedia.com, a spot month refers to the earliest month that the commodity being traded could be delivered. 

Commodity futures typically also have a liquidity requirement built into the contract. As stated on investorwords.com, liquidity refers to the ability of an asset to be converted into cash quickly and without any price discount. In this context, liquidity and liquidity requirements refer to the amount of cash or the amount of the hard assets, needed to be held in order to make trades on margin, or for a price less than 100% of face value. 

Another important facet of commodity futures trading is that of investor classification. Due to the volatile nature of commodity futures markets, and the profound impact that manipulation in those markets can have, regulatory agencies carefully monitor behavior in those markets. In the United States, the Commodity Futures Trading Commission (CFTC) assigns investor categorizations to separate investors with a physical need in the market from speculative investors. Investors with a physical need for the commodity being traded are known as Commercial Participants. Commercial participants typically have little to no restrictions placed on their trading activities because they need the commodity being traded to stay in business. Non-commercial participants, on the other hand, engage in commodity futures trading without a physical need for the products being traded. These investors are more closely monitored and their behaviors more restricted, with regulations like position limits, to ensure that the markets function properly and are not being manipulated for speculative purposes. Were the futures markets to become manipulated they would have an adverse effect on the stock price of companies that rely on those commodities.

Below is a list of commonly traded commodities:

 

Over time, speculation in commodity and futures markets became so prevalent that new commodity oversight legislation had to be created to counter the adverse effects such speculation can have on stock prices in the stock market.

Commodity trading may not be suitable for everyone, as an investor may lose some, all or more than their original investment. The risk of loss in trading futures can be substantial. Before trading, investors should read the “Risk Disclosure Statement” and should understand the risks. Each investor must carefully consider whether futures trading is suitable in light of his or her own financial condition. Before trading, investors should be aware that along with the potential profits there is also potential for losses which may be very large.

 

This material is for general information only and is not a solicitation. Information and opinions presented have been obtained or derived from sources believed to be reliable. Additional information is available upon request. Associates of Chlebina Capital are not registered to offer commodities futures.