Are you interested in becoming involved in commodity trading? Need a little information about just how commodity trading works?

Commodity trading is defined as “a process of exchanging raw and primary products on a regulated exchange, in which those products are bought in standard contracts.” To get a better idea what commodity trading is and how it is performed, let’s first take a look at the differences and similarities between commodity trading and investing in stocks.

Commodity Trading versus Stock Investing

Commodity trading is very similar to the trading of stocks, only the nature of the asset being traded is quite different. People who are buying and trading stocks are in essence buying equity in a particular company, with the hope that the price of those shares will rise in the future. In the commodities market, also known as the futures market, people are buying raw materials, things like corn, wheat and rice, with the hope that the price of those products will also rise.

Both stocks and commodities are traded through a regulated exchange, and both have prices which fluctuate. This potential for both profit and loss is required for both stocks and commodities.

Commodity Trading: A Closer Look at the Commodities Market

As briefly mentioned above, the commodities market is also referred to as the futures market. This is because when individuals purchase the contracts of these products, they are in essence wagering—however calculated—that the price of these materials will rise in the future.

For a product to qualify for the commodities or futures market it must meet the following criteria:

• Products must be standardized and in their raw, unprocessed state. Corn, for instance, is a raw material and would thus qualify as a commodity, processed cornmeal, on the other hand, would not qualify for the futures market.
• Products must have an adequate shelf life, as the purchase on these products is almost always deferred.
• The spot price of a commodity must fluctuate enough to create uncertainty, and therefore a reasonable possibility for both profit and loss.

How Does Commodity Trading Work?

When a person buys a commodities contract, he/she is purchasing a set amount of that product to be delivered in the future. However, in most cases, the actual commodity is rarely ever delivered. Most contracts are sold before the delivery date, creating either profit or loss for the trader.

Unlike stock traders who can hold onto their shares indefinitely, commodity traders agree to pay a certain price for the product at the end of the commodity or futures contract, usually a specific month in a particular year. Usually, though, the commodities are liquidated long before the agreed upon delivery date.

To illustrate this, let’s take a look at a simple example:

Let’s say that you bought 5000 bushels of corn at the price of $3.00 a bushel. This is the price you have agreed to pay when the contract expires. However, during that contract period, you notice that the price of corn has risen to $3.05 per bushel. At this point you can either hold onto the futures contract, hoping the price will rise even higher during the agreed upon period, or liquidate it and receive a profit—in this case, 5 cents for every bushel, or $250 dollars.

Commodity trading can be a very profitable endeavor; however, like stock market options trading, there are always risks to consider as you learn what is commodity trading.