Introduction to financial markets
Trading oil, gold or silver doesn’t require unloading and offloading huge amounts of physical assets. Let’s take a look at how futures and options exchanges enable commodity trading on a global scale.
How are commodities traded?
When commodity consumers want to purchase goods for immediate delivery, they’ll take to the spot market. Here, the buyer can expect delivery of their chosen assets as soon as their trade is settled. When you see a live price for a commodity listed, it will often be the spot price.
However, most speculators don’t want to take immediate delivery of the commodity they’re trading – it would require a level of infrastructure that most traders don't have. So instead, they use derivatives called futures and options to buy and sell gold, oil and more without ever seeing any physical assets.
- Futures enable you to trade a contract today in which you commit to buying or selling a set amount of a commodity for a set price on a set day in the future
- Options give you the right to buy or sell a set amount of a commodity for a set price before the contract expires
The prices of futures and options will move up or down as the spot price of their market moves up or down. This enables commodity speculators to use them to go long (buying) and short (selling) on assets without ever running the risk of taking delivery. Instead, they trade the future or option before it expires.
Gold future example
You trade a gold future today, when gold is trading at $1850. In doing so, you commit to buying ten troy ounces of gold at $1900 in three months.
As your future nears its expiry, gold’s price rises to $1950. Your future now enables you to buy 10 ounces of gold for $50 less than the spot price, saving $500. But because you don’t want to trade any actual gold, you sell your future to somebody else for $450, earning you a $450 profit.
However, futures and options prices aren’t only driven by the underlying price of a commodity. They’ll also take any potential risks and charges that may arise between now and the future’s expiry into account. This is called forward pricing.
Did you know? With FOREX.com, you can speculate on commodities spot markets without your trade expiring. We call these markets ‘non-expiring commodities’.
Producers and futures
Speculators aren’t alone in benefitting from futures contracts. Producers use them to guarantee an income from the commodity they grow or extract. An oil company, for example, can use futures to mitigate against the risk of future oil price volatility.
Investors also use futures, to diversify their portfolio and hedge against negative market moves without having to store large amounts of bullion, oil or other assets.
Where are commodities traded?
Like shares, commodity futures and options are traded on specialised exchanges. Different exchanges around the world will tend to focus on different groups of commodities. A few important ones to know are:
Chicago Board of Trade (CBOT)
Commodities that trade on CBOT include gold, corn, silver, wheat and rice. It is the world’s oldest commodities exchange.
Chicago Mercantile Exchange (CME)
The CME focuses on agricultural commodities – including milk, cattle, pork bellies and lean hogs.
The New York Mercantile Exchange is known for being the most liquid market place for the trading of West Texas Intermediate (WTI) oil futures, as well as a hub for trading energies and some metals.
London Metals Exchange
The LME specialises in industrial metals that do not contain iron, known as non-ferrous metals. These include aluminium, copper and lead.
The London International Financial Futures and Options Exchange focuses on agricultural commodities, such as coffee, sugar and wheat.
Commodity exchanges will only allow permitted professionals to buy and sell contracts on the trading floor – so individual traders will buy and sell futures and options via a broker.
Commodities and leverage
Commodities futures trade in set sizes, depending on the market being traded. A single crude oil future covers 1,000 barrels, for example, while a gold contract covers 100 troy ounces.
That makes most commodity trades fairly large at a minimum. If WTI is trading at $50 per barrel, for example, then buying a single futures contract is the equivalent of trading $50,000 of oil. Some brokers will offer mini contracts, but these still involve trading a sizable amount of each commodity.
To avoid tying up $50,000 each time they want to open a position, most retail commodity traders use leverage. Leverage in commodities works just like in forex, you put down a deposit in order to control a much larger amount of capital.
Instead of using a commodity broker, some individual traders speculate on the futures and spot prices of commodities using derivatives such as CFDs. We’ll go into CFDs in more detail in the Trading with leverage course.
What drives commodity markets?
Commodity markets can be influenced by a range of factors – and each market will have its individual factors affecting supply and demand. However, a few common things to watch out for include:
- Supply interruptions. The supply lines of lots of commodities can be fragile and uncertain. Crops can fail, miners can strike and oil-producing countries can see geopolitical instability that threatens supply. If a commodity becomes scarce but demand remains high, its price will rise
- Fluctuations in demand. Seasons can often bring changes in demand for commodities – for example, from consumers of heating oil and natural gas in the winter. Gold, on the other hand, tends to become more popular during periods of political uncertainty
- General economic slowdowns. Despite attempts to move away from it, the global economy is still built on oil, and if output slows then demand for oil will drop. Many metals, too, can suffer when industry productivity drops
Test your knowledge
- A LIFFE
- B LME
- C NYMEX
- A Future
- B Option
- C Neither
- A It will go up
- B It will go down
- C Nothing