Finance 101 | Commodity Trading, Hedgers, & Speculators

By Michael Chau - Palo Alto High School - CA

Although some people may know what commodity trading is, there are many who do not. To understand this practice, read on for the 101 on commodity trading and why it is such a volatile market.

What is a Commodity?

Simply put, commodities are economic goods for which there is demand for and, no matter whom the supplier is, there is no product differentiation. For example, a barrel of oil is going to be the same product regardless of who sells or produces it.  On the contrary, Nike’s shoes would not be considered commodities since their shoes could be distinct from shoes sold by other companies. In other words, Nike shoes have product differentiation, which sets them apart from commodities.  In addition to the good being standardized, for a commodity to be considered a commodity, it must be usable upon delivery and also the price of the good must fluctuate to a certain extent (so a market can be created for the object). Some examples of commodities are gold, electricity, lumber, and natural gas.

What is Commodity Trading?

To start out with, like buying stocks, commodities are traded at something called an exchange: A marketplace where commodities, futures, and other financial instruments are traded. There are cash markets and futures markets.Cash Market: Transaction complete immediately based on current price of the commodity.Futures Market: Use of futures contracts.Futures are more commonly used than cash markets. Futures contracts obligate the supplier to give buyers a certain quantity of the commodity, at a certain date and price. Futures contracts protect both Hedgers and Speculators from fluctuation of price and also serve as the foundation of how commodities are traded. Hedgers are commodities traders that trade not to gain profit but to hedge against whatever commodities they are selling.For instance, take an oil producer. He produces one thousand barrels of oil daily. In January the cash price is $30 per barrel and futures contracts for March are quoted in January at $30.10 per barrel. To protect himself from losing money, he sells 25 futures contracts for March,locking in $752,500(1000 barrels per contract * 25 contracts, 25000 barrels * $30.10 = $752,000).In February the price of oil falls to $28 so the oil producer sells oil at a cash market for $700,000($28 dollars * 25,000 barrels). He has just earned $50,000 less than what he could have received in January ($2 less * 25,000 barrels).So he goes back to the futures market and buys back the futures contracts of March he sold at $28 per barrel. (The price of the futures has dropped as well since the price of oil dropped). He originally sold the futures contracts earning a total of $752,000 but is buying them back for $700,000 now since the price has dropped. He has earned $52,000 ($752,000 - $700,000) from the futures markets, which accounts for his $50,000 loss in the cash market.

What is a Speculator? 

A Speculator, on the other hand, essentially bets on the future prices of commodities to go up such that he may earn a large, quick profit: essentially, buy low, sell high. Speculators face a lot of risk when trading because:1. Hedgers dominate the market.2. Holding on to a contract for too long causes an assumption you want a delivery of the commodity (e.g. 30 barrels of oil delivered to their door).3. Poorly-timed trades could cause you to go completely bankrupt.Despite these risks, it is still possible for a speculator to earn profit if someone is willing to pay more than the price the speculator bought the commodity at.

Bottom Line

Commodity trading is very risky and definitely not recommended for novice investors.

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