Commodity Trading 101

Stock market of Brussels

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Stocks can make lucrative investments, but also risky ones. When trading stocks, your cash returns are at the mercy of the whims of the businesses in which you have invested your hard-earned money. If you’re looking for a safer investment, you may want to consider commodity trading.

Commodities are generally raw materials or agricultural products (either grown or mined), such as crude oil, coffee beans, gold, silver, wheat, copper, rice, aluminum, etc. What makes commodities so reliable is that their prices are universally fixed – they’re the same whether you’re in California or Zimbabwe. The commodities you acquire will maintain their values across foreign markets and long stretches of time.

Keep in mind this is also subject to local trading conditions, supply & demand, and expenses related to transportation and storage.

Commodities are primarily traded through one of four methods: spot trading, forward contracts, futures contracts, and hedging.

Spot trading is best described as “on the spot” commodity trading. To clarify, let’s use a wholesale fabric store as an example. A spot trade would entail a fabric dealer (let’s call him Michael) approaching a wholesale fabric store with a set price for a set amount of fabric. In a spot trade, Michael would provide the owner of the fabric store (we can call her Sarah) with a sample of the fabric, and Sarah would agree to buy a wholesale amount. The fabric would then either be delivered “on the spot” or at the most immediate convenience for both parties.

Let’s try understanding forward contracts by using the same fabric store scenario. In the case of a forward contract, Sarah would want to buy the fabric, but she would want to buy the fabric in a year from the day of the deal. Michael, knowing that he could make a sale elsewhere and put the money in his bank right away to start accruing interest on it, would set up a “forward price” for Sarah, which would include his original cost plus the amount of interest he would make over a year. Future contracts are very typical of real estate sales.

A futures contract is similar to a forward contract in that the trade occurs at a later date and a set price, typically called the strike price or the future price. Using our wholesale fabric example, Michael might sell fabric to Sarah, at a set price, to be delivered at a set future date (for the sake of this example, let’s say a year from the day of the contract). A futures contract is an interesting investment, in that one of the two parties will come out short, and one will come out long, depending on the increase or decrease of the fabric’s value, over time. If the fabric becomes particularly desirable, and worth more money, within the year, the dealer (Michael) will come out short, and the buyer (Sarah) will come out long. Future contracts generally refer to agricultural sales.

Hedging applies most directly to agricultural commodity trading, because the market value of crops tends to fluctuate. Many commercial farmers plant specific crops, depending on seasonal price forecasts. If seasonal price forecasts exceed the actual prices, the farmer will make a large profit, but if seasonal price forecasts fall below actual prices, the farmer will lose considerable amounts of money. To protect against this kind of fluctuation, the farmer will sign into a hedge contract, in which he sells futures of his crop, at a set price. Although this surrenders his chance of making an extreme profit, it protects him from losing everything.

Commodity trading does not only occur in terms of large sales. You can practice small scale commodity trading by selling your old gold coins and jewelry. Though you don’t necessarily need a broker for this kind of trading, you should do in-depth research before getting into gold sales. Gold sales are most convenient over the web, but there are plenty of online gold scams. Please due your own due diligence and research before committing to any online store. Use resources like the Better Business Bureau, search Google for reviews, and look that you’re not paying an unfair differential from spot.

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  1. says

    Enjoyed the simple explanations. Just on your final point: would you ever recommend these online gold websites? Their prices never seem to represent the true price of gold.

    • says

      The only site I have personally used is Kitco, and I would recommend that. For all other sites — do your research before using them!!! If they are charging too high above spot or don’t have a great reputation, then avoid them.