Let's assume you're biting down onto a lovely bar of chocolate, nice isn't it. Chances are the company that makes that chocolate, has made millions of bars of chocolate all over the World, a good example is Cadbury, but have you ever thought how they secure the price for the cocoa that is used to make that chocolate? Many food products contain soya too, what about the cotton that makes the shirt or blouse you are wearing, or the Orange juice that you are drinking in the morning. How do large manufacturers maintain price future stability in products that they make? The answer is in the commodities market.
The commodities market covers a large and developing list of physical products foods, electricity, metals, oils, gas and so on. Initially the commodity markets was strictly for agricultural purposes. This sprung from the development that ensued over the World in the 19th century. With transportation becoming easier and farming on larger scale allowed for more wholesale pricing of common agricultural items; grains, pigs, cattle and so on. A means to trade this began, which was the foundation of the commodity market that we have today. However, the modern commodity market, contains a greater array of products way beyond that of just agriculturally produced items.
The Commodity Market, much like all the other financial markets that I have been discussing, does have a good degree of duality. By that I mean, it serves it's true aim of providing a means for companies to buy contracts to purchase or sell commodity items at a future set contract price. However, as with the dawn of computers and the rise of the ever-greedy financial markets, there has been an increase in the amount of products that can be traded that are derivatives of this same market. Remember that a derivative, is basically a product created that has no intrinsic value on it's own, other than that of the outcome of the contract closing event of being true or not and to what degree, based on the underlying product.
In fact, apart from stock trading which has no ability to short the market, in other words, make money when the market is going down. When I was young and my father invested in the financial markets, all there was, was the stock market and the futures market. The futures market back then was focused on commodity prices (the underlying) but this same market is what companies use to secure the sale or purchase of commodity items. I remember looking at around 16 years old at the promotional material my father received from his broker about the Futures/Options market. It took me a long time to understand how it worked. I simply couldn't get my head around, that you could own something, but never take delivery of it, you could trade it, but only have to pay a fraction of the amount you are buying (or selling) and if the market moved in your favor you would make money.
In many ways, many people, even today, do not understand truly how the markets work and that most trading these days are based on derivatives, very few actually take delivery of the item they have a contract for. Good job really, as when I did trade futures and options (option to buy (call) or sell (put)), I had little experience and did so not really knowing what I was doing. In fact, if truth be known, I was petrified of having a contract go to expiry as I imagined, very early on, I hasten to add, that I would end up with several tonnes of pork belly meat on my doorstep. Needless to say, my moment trading these was very fleeting, till I found Financial Spread Betting.
Spot trading; allows for delivery of the commodity to be taken immediately, or soon after the transaction has taken place. In other words 'on the spot'. The commodity market does have a lot of standards, so inspection is never required, because all products that are delivered, must meet certain standards. If however, inspection is required, then buyers/sellers cannot market on the commodity markets and must use the 'wholesale market'.
The reason 'Spot Trading' exists, basically allows for a manufacturer to purchase additional product for immediate use. Say for instance if demand of a certain item they are manufacturing is outstripping their current supply of XXXX. Then the company in question will use Spot Trading to purchase more, at the current market price.
Forward Contracts; this is a contract between a buyer and a seller, where the price of the commodity item is agreed on the day the contract was created, with a fulfillment date in the future. Standards vary and samples of product are usually taken, to agree a price and future delivery.
Futures Contracts; now this seems almost identical in terms of Forward Contracts, in that there is a contract between the buyer and seller to agree the sale/purchase of a commodity at a price fixed today, with delivery in the future. However, there is a key difference. Forward contracts are an agreement to deliver and the amounts of commodity are agreed in the contract and the contract is always fulfilled - in other words, the 100 tonnes of belly pork is actually delivered. Where as with Futures contracts, the amounts, grade, standards and so on a preset by market standards and delivery. Most futures contacts are never fulfilled. It is simply the trading of these contracts, that allows for speculation on the commodity markets. However, you can of course take the option to purchase the contract to fruition.
Hedging; hedging in the Commodity Market - allow for groups of suppliers to form a cooperative to insure against poor yields of their commodity through the use of futures contracts in the same commodity in which they supply. Therefore, allowing them to hedge any risk of a poor yield, through the ability to profit from that of taking a speculative trade in the futures market. If the supply of the commodity they produce is in short supply, the futures market for that commodity goes up in value and therefore, the cooperative can still profit with a poor yield.
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