A commodity is a raw material or agricultural product with economic value. Common commodities include:
If you want to explore further, here’s a list of traded commodities.
Commodity prices fluctuate regularly, much like stock prices. That price movement creates both opportunity and risk:
You can use forwards and/or futures for either speculation or hedging. Test questions usually focus on the characteristics of these derivatives - especially how they’re similar and how they differ.
Futures contracts set a “locked-in” price today for a commodity transaction that will occur in the future. Futures share several similarities with options, including:
Like stock options, which typically represent 100 shares per contract, futures contracts cover a specified quantity of a commodity. The exact quantity depends on the commodity, but it’s the same for every contract of that type. For example, a milk futures contract covers delivery of 200,000 pounds of milk. Every milk futures contract covers the same amount, which is what it means for the contract to be standardized.
In a futures contract:
Unlike an option contract, the buyer doesn’t have a right to choose whether to go through with the transaction. A futures contract commits both sides to the future transaction.
Example:
Futures contract for 20 tons of live cattle at $3.
This futures contract would result in:
The futures buyer is bullish, meaning they benefit if the price of live cattle rises. If market prices rise above $3/pound, the buyer has effectively locked in a lower purchase price, creating a gain. If market prices fall below $3/pound, the buyer is still locked into buying at $3/pound, creating a loss.
In practice, the buyer could hold the contract through settlement and actually take delivery of 20 tons of live cattle. However, the vast majority of futures contracts are closed out before that happens. Closing out means the buyer sells the contract before the delivery date, which removes the buyer’s obligation to purchase. It’s estimated that more than 95% of futures contracts do not result in a commodity transaction.
The futures seller is bearish, meaning they benefit if the price of live cattle falls. If market prices fall below $3/pound, the seller has effectively locked in a higher sale price, creating a gain. If market prices rise above $3/pound, the seller is still locked into selling at $3/pound, creating a loss.
Just like the buyer, the seller could hold the contract through settlement and actually deliver the commodity. But because most contracts are closed out, the seller typically exits by buying back the contract before the delivery date, which removes the seller’s obligation to sell.
Because most futures positions are closed out rather than settled with delivery, futures are often used primarily for speculation. That said, futures can also be used to hedge. For example, an investor holding a significant amount of oil company stock might sell oil futures. If oil prices fall and the stock declines, the short oil futures position (bearish on oil) can gain value and help offset the stock losses.
Futures trade on exchanges and typically have low liquidity risk. Standardization helps liquidity: when contracts have consistent terms, market participants can buy and sell them more easily. If every contract were customized, traders would need to evaluate unique terms each time, making active trading much harder.
In summary, here are the important futures test points to be aware of:
Forward contracts also set a “locked-in” price today for a commodity transaction that will occur in the future. They’re similar to futures in several key ways:
So the purpose (a future commodity transaction at a set price) and the obligations of the buyer and seller are the same. The differences are:
Unlike futures, forward contracts are customized to match what the buyer and seller actually need.
Example: Suppose a corn farmer expects a harvest of 2.5 metric tons and plans to deliver the corn to a cereal distributor. Both parties are exposed to price risk:
To hedge against price changes before harvest, the farmer and distributor could enter into a forward contract. Because it’s non-standardized, they can choose a custom quantity (2.5 metric tons) and a custom delivery date.
Because forward contracts are customized, it’s difficult to create an active secondary market for them. As a result, forwards generally have no trading market. Unlike futures, most forward contracts do result in delivery of the commodity. Therefore, forwards are subject to high levels of liquidity risk.
In summary, here are the important test points to be aware of:
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