Commodity trading, quite logically, primarily takes place in commodity markets. This is the first place you would want to go if you have gained interest in trading commodities. These are places in physical or digital locations that offer trading in all sorts of raw natural resources. This could be crude oil, metals, minerals, wheat, livestock, coffee. In short, all of the major materials you would deem necessary. These can be both informal over-the-counter (OTC) systems or exchanges. Different markets favour different commodities, so every trader must establish for themselves where best to trade.
Now you may be thinking to yourself, why do we need these markets? Why can’t the resource extractors sell directly to their consumers? Well, the most important thing to note is that these markets streamline the process. Instead of fumbling around looking for new traders, the market immediately presents you with people willing to trade. It makes the process far faster and easier for you.
Secondly, commodity markets give traders many options. They offer up many possible financial instruments for you to choose from. Traders can have bonds, derivatives, and all sorts of tools to extend their options. For example, they can buy futures contracts. These contracts ensure that a trade takes place at a certain time and for a predetermined price. These types of contracts ensure a trade is agreed upon, and no one backs out at the last minute. It is these kinds of tools that give traders extra confidence in the safety of their trade.
Finally, commodity markets are essential as price-setters of all sorts of commodities.
Roles in commodity markets
The commodity market, of course, requires many different people to transfer the resource to its final destination.
First of all, you have the producers at the very start. They find and extract the resource or grow it themselves. This depends on the type of commodity, of course. They then bring the commodity to the market for selling.
Traders are the middlemen in the equation. They buy the commodity from the producer and sell them on. Their main aim is to profit from the price difference from the buying and selling price. Why can’t producers sell directly to consumers? Well, the main reason is that traders offer an easy way to transfer and store the commodities for everyone else.
Then comes the speculators, who are a type of trader. They do not actually trade the commodity. Rather they consider what the possible price will be and trade with other traders accordingly, attempting to make a profit. While they may not appear to be useful, they ensure there is liquidity in a market and help manage risk.
The traders eventually sell to industrial consumers. These are the people who process the raw materials the traders provide and process it for consumption. They then sell this off to public consumers directly, or more likely to shops, supermarkets, gas stations, etc.
What kinds of Commodity Markets are there?
As we mentioned earlier there are two main varieties of commodity markets. Here we would like a brief discussion of both of them.
OTC commodity markets
These markets are far more informal and most probably resemble older markets more closely. They do take place online, but there is far less regulation in general. OTC markets are platforms that allow you to find traders to exchange goods with. It gives you some of the necessary tools you need, like for arranging derivatives and bonds. Then, it leaves you on your way. You can haggle to the price you want. You can set up your contracts however you like without many restrictions. This both gives you more opportunities for trade but also gives you more risk. So overall, OTC markets are decentralised. These sorts of markets are therefore best used by individuals looking to take risks and make profits.
To continue with this theme, OTC markets are also more likely to be spot markets. Spot markets are places where the trades are more direct, less dependent on contracts. Therefore traders find the price they want and start trading immediately. Due to the fact that there is no waiting time, the prices in these markets tend to differ; they tend to be lower. This does change depending on the particular environment of a market for a particular commodity. So, for example, the Chinese market is way more likely to use spot trading for metals than say Japan. As a result, spot trading in metals in the Asian market is more expensive.
Exchange commodity markets
Exchanges are commodity markets which are far more centralised. They are often under the control of a government body or sometimes some sort of financial institution. The central authority regulates trades and keeps a close eye on everything taking place. These markets are also usually more established, with physical locations. They offer trading both directly and via contracts (derivatives, bonds, etc.). The main difference is that the exchanges offer quite regulated contracts and prices. You don’t have much wriggle room when it comes to contracts or offering new prices. This may seem restrictive, but it offers a certain safety for traders. The people who are most interested in these markets are large companies making large trades and individuals who do not want much hassle in trading. In fact, governments often set up these exchanges to help people who were not financially-inclined, to sell their products.
Since these markets are far more regulated, their main focus is on futures (and forwards) trading. These contracts come standard and are relatively easy to use. Since these contracts are for trades in the future, however, traders have to be careful. They have to consider how the price of a commodity may change in the near future.
Political and economic events can have huge sudden impacts on their value. Look at the Coronavirus epidemic, for example. In the USA, traders still had to go through with their trades for crude oil. This is despite the fact that they knew the market had temporarily abandoned oil. This meant that traders had to get rid of their oil as fast as possible, as they had no more space to store it. This resulted in a situation where the price of oil dropped to a negative for the first time in US oil history.
Options contracts give traders some relief from this kind of situation. It gives traders the option, on the expiry of the contract, to decide whether they complete the transaction. They do have to pay a penalty, of course, but this is a relatively small price to pay. Since traders can cancel a contract, they can always buy more options to counteract previous poor decisions.
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