Definition

• Commodities are raw or partially-processed natural resources whose industrial uses, nutritional significance or other worth and scarcity give them a value conducive to pricing in a market setting. Nonorganic, "hard" commodities include precious metals such as gold, silver, and platinum, as well as crude oil and latex. Organic, "soft" commodities include such items as wheat, corn and fruits, as well as cattle and other livestock.
  
  

Trading

• A commodities exchange is a setting in which commodities are traded at prices determined by supply and demand. Commodity prices fluctuate on a daily basis, and while there are numerous commodities exchanges worldwide, commodity prices are universal. In other words, commodity prices on an exchange in Japan are the same as those in New York and reflect the effects of buying and selling across all exchanges. Commodity future contracts, which are derivative contracts allowing holders to hedge against commodity price risk, are also bought and sold on commodities exchanges.
  
  

Commodity Future Contracts

• Much of commodity trading is done using commodity future contracts. These allow holders to secure a fixed price on a commodity to be paid at a specified date in exchange for a specific quantity of some commodity. The market value, or premium, of a future contract becomes profitable if the market price of the underlying commodity exceeds the price agreed upon in the contract. For example, if an investor believes that oil will be $120.00 per barrel on Dec. 31, 2010, she may purchase an oil future contract from someone who believes the price will only be $100.00 on that date. If the market price of oil is higher than $100.00 on or before Dec. 31, the holder will profit if she sells the contract. The contract becomes more valuable because it allows the holder to purchase oil at a discount. In this sense, future contracts also reduce risk associated with commodity price fluctuations.
  
  

Considerations

• Commodity trading is unique in that, unlike the securities and foreign exchange markets, it is important to account for the physical size of the asset being traded. When commodity traders buy and sell, they are transacting on paper quantities of wheat, oil, silver and other physical substances. Unless a trader specifically wishes to acquire the physical commodity being traded, it's important that he closes out the position (sells the commodity on paper in the market) before the specified delivery and payment date. Failure to do so could result in having to pay not only for potentially high quantities of undesired commodities, but also for costs related to their delivery and storage.
  
  

Warning

• As with trading in any financial market, trading in the commodities market--particularly at the day-trading level--involves a significant amount of risk. Where futures contracts are concerned, a contract's expiration date could coincide with a commodity's significant loss of market value. This would result not only in a loss to the holder, but also the obligation to purchase the commodity at a higher-than-market price.