A commodity is a natural resource that can be processed and sold. Some examples include:
To be officially tradable, a commodity must be entirely interchangeable with another commodity of the same type, regardless of where it came from. For example, gold is gold the world over, it doesn’t matter where it was extracted – so long as it meets certain minimum purity standards.
However, something like beer would not be classified as a tradable commodity as the brewing process creates beers of differing alcohol content and quality.
Types of commodity
There are two main types of commodity:
These are agricultural, typically grown rather than mined or extracted. Softs tend to be very volatile in the short term, as they’re susceptible to growing cycles, weather and spoilage which can alter prices suddenly and dramatically.
Examples include: corn, wheat, rice, cocoa beans, sugar, orange juice.
These are generally mined from the ground, or taken from other natural resources.
Examples include: oil, natural gas, aluminium, copper, silver, gold, lead.
How are commodities traded?
There are two main ways participants can trade commodities in the underlying market:
A commodity is either traded 'on the spot', or a price is agreed today for its purchase at a fixed date in the future
The spot market
If a commodity needs to be acquired immediately, the spot market is the place to go. This is where commodities are sold for cash and exchanged right there and then (or, on the spot).
The futures market
The futures market is where buyers and sellers agree to exchange a specific quantity of an asset at a fixed date in the future, at a price agreed today.
The assets themselves (gold, oil, rice, etc) are not physically traded, so participants buy and sell futures contracts instead. Often the contracts are closed before the actual delivery date, enabling participants to trade on the price of the commodity, without needing to own it at any stage.
The price of a futures contract tends to be different from buying or selling an identical amount of that same commodity on the spot market, as the seller needs to account for future risks and charges, such as the cost to hold the commodity and then transport it to the buyer. Hence futures contracts are valued using forward prices, rather than spot prices.
Where are commodities traded?
Like shares, commodities are traded via a global network of specific exchanges. Each exchange specialises in particular types of commodity, for example:
- London Metal Exchange – non-precious metals
- Chicago Mercantile Exchange – energy and metals
- Chicago Board of Trade – agricultural products
- ICE Futures US – agricultural products and energy
- ICE Futures Europe – agricultural products and energy
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