Commodities and futures often go hand in hand, although the terms represent different concepts. Commodities are things you can buy or sell -- physical goods such as oil, grain or metals. Futures are contracts to buy and sell things in the future. They come together in commodity futures -- contracts that arrange trades in commodities.
A commodity is any good -- often a raw material -- that is uniform enough that the source of the good doesn't really matter. Gold makes an excellent introductory example: An ounce of gold mined in South Africa has the same properties as an ounce mined in Russia or the Rocky Mountains. If you need an ounce of gold, an ounce from any of those places will do. They're interchangeable, and that's what makes gold a commodity. Crude oil is a commodity, as are corn, wheat, zinc, copper, pork bellies and feeder cattle. With some commodities, such as petroleum or agricultural products, small differences in quality might exist from one source to the next, but they're not enough to establish one source as preferable to others.
While a commodity is a good that gets traded, a futures contract is a mechanism for carrying out such trades. Futures are agreements to buy or sell a quantity of something at a set price on a specific date in the future. That "something" can be commodities, shares of stock, bonds, currencies -- just about anything of value. Unlike an option, which merely gives the holder an opportunity to buy or sell something, a futures contract is an obligation. If you hold a futures contract to buy, say, 100,000 bushels of corn, you're on the hook to buy the corn -- unless you sell the contract to someone else.
Commodities exchanges exist to facilitate trades in futures on high-demand commodities. The Chicago Board of Trade, the New York Mercantile Exchange and the London Metal Exchange are among the most famous of the dozens of major exchanges around the world. Producers and end users of commodities use these markets to lock in prices. However, the vast majority of trades involving commodities don't actually lead to delivery. When a trader takes out a futures contract to purchase 100,000 bushels of corn at a given price, that trader usually doesn't expect (or want) to wind up with 100,000 bushels of corn. Rather, the trader is either speculating or hedging.
Speculation and Hedging
A speculator buys commodity futures in an attempt to profit from the changing value of the underlying commodity, which will affect the value of the contract. The hedger, on the other hand, tries to limit exposure to risk. Say a trader has a position that will lose money if the price of corn rises. By taking out futures contracts that will increase in value if corn prices rise, the trader can counterbalance, or hedge, that risk.
Video of the Day
- Jupiterimages/Photos.com/Getty Images