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

A commodity market is where you can buy and sell goods taken from the earth, from cattle to gold, oil to oranges, and orange juice to wheat. Commodities can be turned into products like baked goods, gasoline, or high-end jewelry, which in turn are bought and sold by consumers and other businesses. Markets in these goods are the oldest in the world, but they are as crucial to the most modern societies as they were to the small trading communities of ancient civilizations.

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, while soft commodities are agricultural products or livestock, such as corn, wheat, coffee, sugar, soybeans, and pork. They are traded directly in spot markets or financial commodity markets through contracts for them or their future prices.

How Commodity Markets Work

Commodity markets have existed since very early in human history. They were and still are found in bustling town squares or along ports where traders and consumers buy and sell grains, haggle over livestock and meat, or try to leave some money to spare for whatever else came in with the harvest. These traditional markets have served as the physical backbone for exchanging the raw materials upon which societies were built and on which we survive.

Yet, alongside and within these markets, there is a parallel world of financial commodity markets. Here, traders don't swap bushels of wheat or bales of cotton. Instead, they enter into trade agreements on the future prices of these goods through contracts known as forwards, which were standardized into futures and options in the 19th century. Without these markets, farmers couldn't ensure they get the prices they need for their harvest to plant seeds the following year, and so the regular commodity market has often relied on what happens in the financial commodity markets, which exert extraordinary influence on our daily lives. These financial markets don't directly handle the commodities themselves—though a trader may be on the hook for delivering them in the future—but enable trading in interchangeable agreements in regulated exchanges. These markets help airlines hedge against rising fuel costs, farmers lock in grain prices ahead of their harvest, and speculators wager on everything from gold to coffee beans.

Producers and consumers of commodity products can access them in centralized and liquid commodity markets. 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. The U.S. Commodity Exchange Act (CEA) from 1936 provides this thorough definition of commodities, which includes both physical products and the contracts traded for them:

The term “commodity” includes wheat, cotton, rice, corn, oats, barley, rye, flaxseed, grain sorghums, mill feeds, butter, eggs, Solanum tuberosum (Irish potatoes), wool, wool tops, fats and oils (including lard, tallow, cottonseed oil, peanut oil, soybean oil, and all other fats and oils), cottonseed meal, cottonseed, peanuts, soybeans, soybean meal, livestock, livestock products, and frozen concentrated orange juice, and all other goods and articles, except onions as provided in Public Law 85– 839 (7 U.S.C. 13– 1), and all services, rights, and interests in which contracts for future delivery are presently or in the future dealt in.

Certain commodities, such as precious metals, are considered a 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.

Types of Commodity Markets

Generally speaking, commodities trade either in spot markets or financial commodity or derivatives markets. Spot markets can be physical or“cash markets” where people and companies buy and sell physical commodities for immediate delivery.

Derivatives markets involve forwards, futures, and options. Forwards and futures are derivatives contracts that rely on the spot prices of commodities. 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 roll overor close out their contracts to avoid making or taking delivery altogether. Forwards and futures are generally the same, except that forwards are customizable and trade over-the-counter, while futures are standardized and traded on exchanges.

History of Commodity Markets

Commodity trading predates that of stocks and bonds by many centuries. Trading commodities goes back to the dawn of human civilization as loosely affiliated villages and clans would barter and trade with one another for food, supplies, and other items. The rise of empires across the ancient civilizations of Africa, the Americas, Asia, and Europe can be directly linked to their ability to create complex trading systems and facilitate the exchange of commodities across vast territories via major trade routes like the Silk Road.

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.

Commodity markets in the U.S. stretch back to the earliest colonial days—in fact, the goods bought and sold were largely the impetus for European colonialism in the first place—with centralized marketplaces eventually emerging in bustling cities to trade like tobacco, timber, and grains. Early on, farmers and merchants relied on forward contracts to manage costs when there were problems (either too much or too little) in supply chains.

The Chicago Board of Trade (CBOT), founded in 1848, standardized how grain futures were traded. Other specialized exchanges arose for cotton, livestock, and metals. The exchanges brought badly needed transparency and structure to chaotic markets where "corners" (as in "cornering" the market) weren't even banned until 1868. Shady operations dubbed "bucket shops" preyed on the inexperienced, leading to losses and a lack of faith in the market. In response, states initially enacted a patchwork of legislation, including some banning commodity derivatives (options and futures) altogether.

The Grain Future Act of 1922 represented a turning point. The law put in place reporting requirements and attempted to limit price fluctuations by mandating all grain futures to be traded on regulated futures exchanges. In the turbulent years moving into the 1930s, American commodity markets had many well-publicized scandals. Speculators fueled wild price swings that threatened to crush farmers and starve those already facing the ravages of the Great Depression. In light of these stark circ*mstances, the CEA was enacted in 1936. Its most tangible result was establishing the Commodity Exchange Commission (CEC) as an independent agency under the Department of Agriculture. The CEC was given regulatory muscle to set licensing standards for exchanges and brokers, regulate trading practices, and tighten policies to safeguard investors. Most important among these would be the CEC's monitoring of large market positions to enforce trading limits and preempt attempts to corner the market or engineer chaotic price swings.

In the following decades, the CEC's authority would expand to cover more and more commodities. By the early 1970s, Americans were facing higher fuel costs, rising unemployment, and an economy teetering toward what would become the stagflation of the 1970s. In 1973, grain, soybean, and other futures prices hit records, with the blame put on speculators in the market. This led to amendments to the CEA in 1974 that created the Commodity Futures Trading Commission (CFTC) and expanded its remit to include precious metals and financial futures.

These regulatory attempts laid bare the fundamental tension in commodity markets. How to rein in excessive speculation and shut down manipulative practices while allowing these markets to facilitate legitimate trade and price discovery? As an independent body, the CFTC inherited the oversight duties outlined in the heavily amended CEA. However, it encountered a growing universe of complex financial products, including options, foreign currency futures, and the mushrooming interest rate derivatives market. Early successes in cracking down on fraud and protecting market participants were punctuated by occasional scandals (in 1978, it had to ban so-called "London options" because of fraud, and the next year halted trading in March wheat futures to stop price manipulation in that market), revealing the ongoing battle between regulators and sophisticated players seeking to exploit any new opportunity.

Technological revolutions transformed the industry as computerized and eventually network-driven trading became the norm. In 2008, the financial crisis and the tripling in price of wheat futures gave rise to calls for further regulations. The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 expanded the CFTC's jurisdiction to include over-the-counter derivatives like swaps.

Today, U.S. commodity exchanges list options andfutures contractson a wide range of products, including gold, silver, U.S.Treasury bonds, energy, and weather-related and other events. In 2007, the CME Group merged with the CBOT, adding interest rates and equity index products. That same year, the New York Board of Trade merged with Intercontinental Exchange (ICE), forming ICE Futures U.S. In 2008, the CME acquired the New York Mercantile Exchange (NYMEX) and the Commodity Exchange Inc. Each exchange offers a wide range of global benchmarks across major asset classes.

Examples of Commodities Markets

The major commodity exchanges in the U.S. are mostly in Chicago and New York, and they specialize in particular commodities or a whole range of them. For example, commodities traded on the CBOT include corn, gold, silver, soybeans, wheat, oats, rice, and ethanol. The CME trades commodities such as milk, butter, feeder cattle, cattle, pork bellies, lumber, and lean hogs.

NYMEX trades oil, natural gas, gold, silver, copper, aluminum, palladium, platinum, heating oil, propane, and electricity, and ICE Futures U.S. is where to look for trades in coffee, cocoa, orange juice, sugar, and ethanol.

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

Commodity Market Requirements

In the U.S., the CFTC regulates commodity futures and options markets. The CFTC is legally called on to promote competitive, efficient, and transparent markets that help protect consumers from fraud and other unscrupulous practices. This also helps facilitate interstate commerce incommoditiesby regulating transactions on commodityexchanges. For example, regulations set out to limit excessive speculative 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.

Commodity Market Trading vs. Stock Trading

Wall Street is synonymous with images of stock tickers and bustling traders, emblematic of company ownership stakes. At the same time, markets in commodities can conjure everything from humble flea market-like stalls to traders crying out to be heard on the floor of an exchange. For investors, it's important to know the differences in what's traded on which exchanges. Here are some of the essential differences:

What's traded: The primary distinction lies in the nature of the assets. Stocks are fractional ownership in a corporation, with their value closely aligned with the company's performance or market sentiment about the firm. Commodities, meanwhile, are physical goods with their investment appeal often hinging on supply and demand and factors like weather conditions, geopolitical developments, and industry changes.

Who's trading: Both markets draw institutional investors and hedge funds but diverge in their other participants. The stock market is where companies seeking to raise capital go, met by a diverse range of retail investors, often willing to do so. The commodity market, by contrast, is for producers like farmers and mining companies, processors, manufacturers, or other end-users (for example, airlines that need fuel) who need a direct link to the tangible economy.

Returns and income: Stocks provide returns in two main ways: capital appreciation (when the stock goes up) and dividends (periodic payments made from the company's profits to shareholders). Commodities, however, do not offer dividends. Instead, commodity returns are primarily generated from profits made from buying low and selling high. In addition, investors in commodity futures can gain or lose from commodity futures contracts.

Risks involved: Both markets are fraught with risks. Corporate actions, economic trends, and market sentiment often influence stock values. Commodity prices, known for their volatility, can have dramatic shifts in light of geopolitical events, weather, or excess speculation. Yet, commodities can effectively hedge against inflation, potentially mitigating risks from a stock-heavy portfolio.

Trading methods: Stock trading is primarily electronic and centralized through major exchanges like Nasdaq and the New York Stock Exchange. Commodity trading, while now found on electronic platforms, still retains elements of traditional physical trading (e.g., grain silos, freezer cars transporting meat) alongside the complex world of futures and options contracts, which can mean greater complexity for investors.

Navigating the commodity markets requires a good understanding of supply chains and global events, extending well beyond financial analyses, which can be challenging enough. Individual investors may find trading commodity-focused exchange-traded funds (ETFs) or shares in commodity-focused companies easier.

The Bottom Line

Commodities markets are where tangible goods and contracts based on them are traded. 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 these assets to your portfolio.