Special Features of Commodities Trading

Trading commodities is fundamentally different from other asset classes, such as stock trading. For example, commodity trading is somewhat more complex, but has been increasingly facilitated by derivatives and CFDs for private investors.

While the private investor can book shares in his custody account, he simply does not want to be supplied with 100 barrels of WTI crude oil just because he has purchased corresponding contracts on the commodity futures exchange.

Therefore, it requires certain parameters, structures and specificities in the respective contracts of different commodities.

Why are commodities traded in contract form?

Every good farmer but also industrialist wants to be sure when it comes to his harvest or his products. He will therefore like to sell his goods before or even in the early stages of production.

Mainly these reasons produced the ever-evolving and growing commodity markets. As a result, the markets and also the respective regional and national commodity futures exchanges grew to huge transshipment points.

As most commodities can not only be traded through the spot / spot market (commodities for money), other trading instruments must be available - the futures.

Commodity trading is thus mainly about commodity futures in the form of traded futures contracts .

The farmer's commodity futures business can then refer to a specific product ( wheat , corn , ...) that is traded on time. In this way, the farmer can sell his product in advance on appointment and may also hedge against price fluctuations.

Conversely, this also pleases the purchaser, who then also has planning certainty for his storage with regard to future production costs. He can protect himself from supply bottlenecks and avoid excessive hedging or hedging .

Why are not all commodities traded on the spot market?

Most of the commodities are not available to the investor through the spot market. Exceptions here are the precious metals. Gold , silver , platinum and palladium can be bought and sold through the spot market. For most commodities, however, trading is only possible as a future.

Imagine you want to invest in pork belly halves and speculate on rising prices. If you were to purchase this product through the spot market, the goods would be delivered to you and you would have high transport costs, high storage costs (perishable goods must be cooled consuming) and you would have to keep the goods until their planned sale.

This form of trading raw materials can not be successful. For this reason, private investors will not want to buy and sell commodities via the spot markets.

Only producers, entrepreneurs and wholesalers are active on the physical commodities market. To develop investment and trading channels, trading was developed in the form of futures in contracts . In addition, the quality of the raw material is very well defined.

What are futures?

By definition, a future is a standardized contract that determines the timing, price, quantity and quality of the commodity to be delivered.

Each contract (contract) has a term. After expiry of this specific term, the seller is obliged to deliver and the buyer for acceptance. In both cases, the terms of each contract.

Through these design possibilities of the respective contracts, investors, producers, farmers, companies, in short for all parties involved in the economic cycle, develop a multiplicity of trading possibilities with defined rules.

What happens when the futures contract expires?

Due to the term limits of the respective contracts, the commodity futures exchanges will expire at the end of the term of a contract for the maturity event. The goods would be due at the end of the term or would be available for delivery. To avoid this event, the soon-to-be-sold contract will be sold.

The proceeds from this sale will be used to buy the new contract with a longer term. Depending on the commodity, however, the respective contract terms and maturity dates differ. This process is called "Rollover" or "roll". The soon expiring contract will be rolled into the following contract.

Rollover and pricing: backwardation and contango

Rolling operations (rollovers) have a certain effect on the price formation in the respective contract. The closer the next contract is chosen (in terms of time), the more liquid the market for this contract will be. Investors basically pursue the strategy of switching to the next future with the shortest possible maturity.

The rolling process itself can have two sides. If the new contract is priced higher then a premium is payable. This process is called " Contango ". If the price is lower, the investor has to pay less for the new contract. This process is called backwardation . The commodity Trader can therefore book roll losses or roll profits.

A contango situation indicates a rising forward market curve, a backwardation situation indicates a falling forward market curve.