Commodity Market: Definition, Types, Example, and How It Works (2024)

A commodity market is a marketplace for buying, selling, and trading raw materials or primary products.

Commodities are often split into two broad categories: hard and soft commodities. Hard commodities include natural resources that must be mined or extracted, such as gold, rubber, and oil, whereas soft commodities are agricultural products or livestock, such as corn, wheat, coffee, sugar, soybeans, and pork.

Key Takeaways

A commodity market involves buying, selling, or trading a raw product, such as oil, gold, or coffee.
There are hard commodities, which are generally natural resources, and soft commodities, which are livestock or agricultural goods.
Spot commodities markets involve immediate delivery, while derivatives markets entail delivery in the future.
Investors can gain exposure to commodities by investing in companies that have exposure to commodities or by investing in commodities directly via futures contracts.
The major U.S. commodity exchanges are ICE Futures U.S. and the CME Group, which holds four major exchanges: the Chicago Board of Trade, the Chicago Mercantile Exchange, the New York Mercantile Exchange, and the Commodity Exchange, Inc.

Commodity Market: Definition, Types, Example, and How It Works (1)

How Commodity Markets Work

Commodities markets allow producers and consumers of commodity products to gain access to them in a centralized and liquid marketplace. These market actors can also use commodities derivatives to hedge future consumption or production. Speculators, investors, and arbitrageurs also play an active role in these markets.

Certain commodities, such as precious metals, have been thought to be a good hedge against inflation, and a broad set of commodities as an alternative asset class can help diversify a portfolio. Because the prices of commodities tend to move in opposition to stocks, some investors also rely on commodities during periods of market volatility.

In the past, commodities trading required significant amounts of time, money, and expertise, and was primarily limited to professional traders. Today, there are more options for participating in the commodity markets.

History of Commodity Markets

Trading commodities goes back to the dawn of human civilization as tribal clans and newly established kingdoms would barter and trade with one another for food, supplies, and other items. Commodity trading predates that of stocks and bonds by many centuries. The rise of empires such as ancient Greece and Rome can be directly linked to their ability to create complex trading systems and facilitate the exchange of commodities across vast swaths via routes like the famous Silk Road that linked Europe to the Far East.

Today, commodities are still exchanged throughout the world—and on a massive scale. Trading has also become more sophisticated with the advent of exchanges and derivatives markets. Exchanges regulate and standardize commodity trading, allowing for liquid and efficient markets.

The majority of exchanges carry at least a few different commodities, although some specialize in a single group.

Types of Commodity Markets

Generally speaking, commodities trade either in spot markets or derivatives markets. Spot markets are also referred to as“physical markets” or“cash markets” where buyers and sellers exchange physical commodities for immediate delivery.

Derivatives markets involve forwards, futures, and options. Forwards and futures are derivatives contracts that use the spot market as the underlying asset. These are contracts that give the owner control of the underlying asset at some point in the future, for a price agreed upon today. Only when the contracts expire would physical delivery of the commodity or other asset take place, and often traders willroll overor close out their contracts in order to avoid making or taking delivery altogether.

Commodity trading conducted outside the operation of the exchanges is referred to as the over-the-counter (OTC) market.

Forwards and futures are generally the same, except that forwards are customizable and trade over-the-counter, whereas futures are standardized and traded on exchanges.

Examples of Commodities Markets

The major exchanges in the U.S., which trade commodities, are domiciled in Chicago and New York, with several exchanges in other locations within the country. Commodities traded on the CBOT, for example, include corn, gold, silver, soybeans, wheat, oats, rice, and ethanol. The Chicago Mercantile Exchange (CME) trades commodities such as milk, butter, feeder cattle, cattle, pork bellies, lumber, and lean hogs.

The New York Mercantile Exchange (NYMEX) trades commodities on its exchange, such as oil, natural gas, gold, silver, copper, aluminum, palladium, platinum, heating oil, propane, and electricity. Formerly known as the New York Board of Trade (NYBOT), ICE Futures U.S. commodities include coffee, cocoa, orange juice, sugar, and ethanol on its exchange.

The London Metal Exchange and Tokyo Commodity Exchange are prominent international commodity exchanges.

Commodities are predominantly traded electronically; however, several U.S. exchanges still use the open outcry method.

Commodity Market Requirements

In the U.S., the Commodity Futures Trading Commission (CFTC) regulates commodity futures and options markets. The CFTC's objective is to promote competitive, efficient, and transparent markets that help protect consumers from fraud and unscrupulous practices. The CFTC and related regulations were designed to prevent and remove obstructions to interstate commerce incommoditiesby regulating transactions on commodityexchanges. For example, regulations look to limit or abolish short selling and eliminate the possibility of market and pricemanipulation, such as cornering markets.

The law that established the CFTC has been updated several times since it was created, most notably in the wake of the2007-2008 financial crisis. TheDodd-Frank Wall Street Reform and Consumer Protection Actgave the CFTC authority over theswaps market, which was previously unregulated.

Regulation of commodity markets remains in the spotlight after ten leading investment banks were caught up in an international precious metals manipulation probe by the CFTC and U.S. Department of Justice in 2015.

Commodity Market Trading vs. Stock Trading

For most individual investors, accessing commodities markets, whether spot or derivatives, is untenable. Direct access to these markets typically requires a special brokerage account and/or certain permissions. Because commodities are considered an alternative asset class, pooled funds that traded commodities futures, such as CTAs, typically only allow accredited investors. Still, ordinary investors can gain indirect access to commodities via the stock market itself. Stocks on mining or materials companies tend to be correlated with commodities prices, and there are various ETFs now that track various commodities or commodities indexes.

Investors looking to diversify their portfolio can look to these ETFs, but for most long-term investors, stocks and bonds will make up the core of their holdings. Moreover, because commodity prices tend to be more volatile than stocks and bonds, commodities trading is often most suited for those with higher risk tolerance and/or longer time horizons.

How Do I Find Out How the Commodity Markets Are Doing Today?

Many online financial portals will provide some indication of certain commodities prices such as gold and crude oil. You can also find prices on the websites of commodity exchanges.

What Do Commodities Traders Do?

Commodities traders buy and sell either physical (spot) commodities or derivatives contracts that use a physical commodity as its underlying. Depending on what type of trader you are, you will use this market for different purposes, for instance, buying or selling a physical product, hedging, speculating, or arbitraging.

Are Commodities a Good Investment?

Like any investment, commodities can be a good investment but also come with risks. To invest in commodities, an investor needs to understand the markets of the commodity they wish to trade in. For example, oil prices can fluctuate based on the political climate in the Middle East, so a trader should be well-versed in current events in that area.

The type of investment also matters. ETFs provide more diversification and lower risks, whereas futures are more speculative, and the risks are higher because of margin requirements. That being said, commodities can be a hedge against inflation, and gold, in particular, can be a hedge against a market downturn.

How Do Commodities Markets Work?

For spot markets, buyers and sellers exchange cash for immediate delivery of the physical product. In derivatives markets, buyers and sellers exchange cash for the right to future delivery of that product. Oftentimes, derivatives holders will roll over or close out their positions before delivery can happen. Forwards trade over the counter and are customized between counterparties. Futures and options are listed on exchanges and have standardized contracts that are more highly regulated.

What Are Some Examples of Commodities?

There are several commodities available. Energy products include crude oil, natural gas, and gasoline. Precious metals include gold, silver, and platinum. Agricultural products include wheat, corn, soybeans, and livestock. Other commodities you can trade are coffee, sugar, cotton, and frozen orange juice. These commodities and many more can be purchased and traded using forward contracts, future contracts, and options.

The Bottom Line

Trading commodities can be a way to diversify holdings, hedge against inflation, and realize a profit, but traders should have a high tolerance for risk if they choose this path. As with other high-risk, high-reward trading opportunities, be sure you know and understand the strategies behind trading commodities and their derivatives before you add this asset type to your portfolio.