How are commodities traded?

Commodity markets allow participants to buy, sell and manage exposure to raw materials such as gold, oil, natural gas and agricultural products.

Two important concepts for beginners are the spot market and the futures market.

What is the spot market?

A spot market refers to transactions based on the current market price, generally involving settlement in the near term according to the conventions of that market.

The current market price is known as the spot price.

Businesses may use physical commodity markets when they genuinely need the underlying material.

For example, a manufacturer may need copper for production.

What is the futures market?

A futures contract is an agreement to buy or sell an asset according to specified terms at a future date.

Commodity futures are widely used by both commercial businesses and financial market participants.

For example, an agricultural producer may use futures to help manage uncertainty around the future selling price of a crop.

A trader, meanwhile, may trade futures because they expect the market price to change without intending to take physical delivery.

What is a commodity contract?

Futures exchanges standardise their contracts.

Each contract defines characteristics such as:

• Underlying commodity

• Contract quantity

• Expiry

• Pricing unit

• Delivery or settlement terms

Contract specifications can differ significantly between commodities.

Traders therefore need to understand the exact contract specification before trading.

What moves commodity prices?

Supply and demand remain the foundation of commodity pricing.

However, many different factors can change them.

Supply

Supply can be affected by:

• Production levels

• Mining output

• Agricultural harvests

• Inventories

• Transportation disruptions

Demand

Demand may increase or decrease as economic conditions change.

Rapid economic growth, for example, can increase demand for energy and industrial metals.

Weather

Weather conditions can have a major impact on agricultural production.

Droughts, floods or extreme temperatures may reduce crop output and affect prices.

Geopolitical events

Conflicts, sanctions and political instability can disrupt commodity production or transportation.

Energy markets can be particularly sensitive to these developments.

Currency movements

Many globally traded commodities are commonly quoted in US dollars.

Changes in the dollar can therefore interact with commodity prices, although the relationship is not fixed and many other factors may be more important at any given time.

Market expectations

As with other financial markets, prices respond not only to current conditions but also to what market participants expect supply and demand to look like in the future.

Why are commodity markets volatile?

Supply can sometimes take considerable time to adjust.

A gold mine cannot instantly increase production because prices rise.

Farmers cannot immediately produce another harvest.

Oil producers may also face operational or geopolitical constraints.

When demand changes more quickly than supply can respond, commodity prices can experience significant movements.

This volatility can create trading opportunities, but it also increases risk.

Course summary

You have now covered the foundations of four major areas of the financial markets:

Financial trading

• Trading involves taking positions based on changes in financial-market prices.

Shares

• Shares represent ownership in publicly listed companies.

Stock indices

• Indices track groups of shares and provide a broader picture of equity-market performance.

Forex

• Foreign exchange involves trading one currency relative to another.

Commodities

• Commodity markets cover physical resources such as metals, energy and agricultural products.

Across all of these markets, one principle remains constant:

Prices change as supply, demand, expectations and new information change.

Understanding what causes those movements is one of the foundations of becoming a more informed market participant.

The next stage is learning how traders analyse those movements, place orders and manage the risk associated with every trading decision.