commodity

What It Is

A commodity is any homogenous good traded in bulk on an exchange.

How It Works

Grain, precious metals, electricity, oil, beef, orange juice, and natural gas are traditional examples of commodities, but foreign currencies, emissions credits, bandwidth, and certain financial instruments are also part of today's commodity markets. According to the New York Mercantile Exchange, "A market will flourish for almost any commodity as long as there is an active pool of buyers and sellers."

To be considered a commodity, an item must satisfy three conditions:

-- It must be standardized (for agricultural and industrial commodities it must be in a "raw" state).

-- It must be usable (i.e., have a shelf life) upon delivery.

-- Its price must vary enough to justify creating a market for the item.

The world of commodities is complex, fascinating, and has a profound effect on economies and consumers around the world.

How Commodities Are Traded
Buyers and sellers can trade a commodity either in the spot market (sometimes called the cash market), whereby the buyer and seller immediately complete their transaction based on current prices, or in the futures market.

Most buyers and sellers trade commodities on the futures markets because many commodity producers -- particularly those of traditional commodities like grain -- bear the risk of potentially negative price changes when their products are finally ready for the market. Futures contracts, whereby the buyer purchases the obligation to receive a specific quantity of the commodity at a specific date and at a specific price, therefore offer some price stability to commodity producers and commodity users.

Futures contracts are standardized, meaning that each commodity has the same specifications for the product's quality, quantity, and delivery. This helps ensure that all prices mean the same thing to everyone in the market. Crude oil is an example of a traditional commodity that is frequently traded using futures contracts. Because each kind of crude oil (light sweet crude, for example) meets the same quality specifications, buyers know exactly what they're getting, regardless of the source of the oil. However, sometimes producers attempt to brand their products in an effort to obtain higher prices.

As in any futures trading, there are those who hedge and those who speculate on commodities. Hedgers do not usually seek a profit; they trade primarily to protect against rising (or falling) prices to stabilize the costs (or revenues) of their business operations. A cereal manufacturer, for example, might wish to hedge against rising costs of certain grains, which could drive up raw materials costs, increase cost of goods sold, and crimp gross profit margins. Speculators, on the other hand, are strictly in pursuit of profits and are essentially placing bets on the future prices of certain commodities.

Regulation
The Commodity Futures Trading Commission (CFTC) regulates commodities futures trading through its enforcement of the Commodity Exchange Act of 1974 and the Commodity Futures Modernization Act of 2000. The CFTC works to ensure the competitiveness, efficiency, and integrity of the commodities futures markets and protects against manipulation, abusive trading, and fraud.

Commodities Exchanges
There are six major commodity exchanges in the U.S.: The New York Mercantile Exchange (NYMEX), the Chicago Board of Trade (CBOT), the Chicago Mercantile Exchange, the Chicago Board of Options Exchange (CBOE), the Kansas City Board of Trade, and the Minneapolis Grain Exchange. The New York Mercantile Exchange is the world's largest physical commodity futures exchange. When the hours for open outcry and electronic trading are combined, some exchanges are open for nearly 22 hours a day.

Commodities exchanges do not set the prices of the traded commodities. Instead, supply and demand determine commodities prices. Exchange members, who act on behalf of their customers or for their own account, engage in open-outcry auctions in pits on the exchange floors. During an open-outcry auction, buyers and sellers announce their bids and offers. When two parties agree on a price, the trade is recorded both manually and electronically. The exchange then disseminates the price information to news services and other reporting agencies around the world.

Commodities exchanges guarantee each trade using clearing members who are responsible for managing the payments between buyer and seller. Clearing members -- usually large banks and financial services companies -- require traders to make good-faith deposits (called margins) in order to ensure they have sufficient funds to handle potential losses and will therefore not default on their trades. The risk borne by clearing members lends further support to the strict quality, quantity, and delivery specifications of commodities futures contracts.

Why It Matters

Commodities are the raw materials used by virtually everyone. The orange juice on your breakfast table, the gas in your car, the meat on your dinner plate, and the cotton in your shirt all probably interacted with a commodities exchange at one point. Commodities exchange participants set or at least influence the prices of many goods used by companies and individuals around the globe. Changes in commodity prices can affect entire segments of an economy, and these changes can in turn spur political action (in the form of subsidies, tax changes, or other policy shifts) and social action (in the form of substitution, innovation, or other supply-and-demand activity).

In general, however, the liquidity and stability of the commodities exchanges helps producers, manufacturers, other companies, and even entire economies operate more efficiently and more competitively.

Source: Investing Answers