Commodities — clear definition
– A commodity is a basic, largely interchangeable raw material used to produce other goods or services. Examples include crude oil, wheat, gold, natural gas and other primary inputs.
– When traded, commodities are standardized to meet minimum quality or “basis grade” standards so units from different producers are mutually acceptable.
How commodity markets work (short)
– Exchanges standardize contracts (quantity, quality, delivery month). That lets many buyers and sellers trade large volumes without handling the physical product.
– Derivative contracts tied to commodities include forwards, futures and options. These permit price transfer, hedging, and speculation without immediate physical delivery.
Two common market participants
1. Buyers and producers (hedgers): Commercial users and producers of a commodity use futures/forwards to lock in prices and reduce the risk of adverse price moves. They may take or make physical delivery when contracts expire.
2. Speculators: Traders who seek to profit from price movements and generally do not intend to take physical delivery. Speculation adds liquidity and price discovery to the market.
What determines commodity prices
– Supply and demand drive prices. Factors that shift supply or demand include economic growth, weather or crop outcomes, extraction disruptions, natural disasters, and investor flows (for example, demand for inflation hedges).
– Because commodities often move independently of stocks and bonds, they can play a diversification role in a portfolio.
Commodity vs. asset vs. security — short definitions
– Commodity: physical input consumed or transformed in production.
– Asset: anything of value that can be held or owned; many assets (e.g., machinery) are not consumed in one use.
– Security: a financial instrument representing a legal claim on future cash flows (e.g., stock or bond); securities are not physical commodities.
Types of commodities
– Hard commodities: mined or extracted (metals, ores, petroleum/energy).
– Soft commodities: grown or agricultural products (wheat, coffee, cotton, sugar).
Where commodities trade
– Major U.S. venues include ICE Futures U.S. and CME Group exchanges (which operate the Chicago Board of Trade, Chicago Mercantile Exchange, and others).
– Trades are typically conducted via standardized futures contracts or other derivatives.
Practical checklist before gaining exposure
– Contract specs: confirm contract size and the required grade (e.g., CBOT wheat = 5,000 bushels).
– Expiration/delivery: know delivery months and whether you must close a position before physical delivery.
– Margin and leverage: understand initial and maintenance margin requirements and the leverage involved.
– Liquidity and bid/ask spreads: prefer liquid contracts for lower trading costs.
– Storage and carry costs: for physical holders or when roll yield matters (in futures ETFs that roll contracts).
– Tax treatment: check how gains/losses are taxed in your jurisdiction.
– Correlation/diversification: assess how the commodity fits with other holdings and your objectives.
– Access method: evaluate futures, commodity mutual funds/ETFs, commodity-linked securities, or owning the physical good if applicable.
Worked numeric example — a simple hedging case (farmer)
Assumptions:
– Expected harvest: 100,000 bushels of wheat.
– Exchange contract size: 5,000 bushels per futures contract.
– Current futures price when hedge is placed: $5.00 per bushel.
– Price at harvest (spot): $4.50 per bushel.
Steps and result:
1. Number of contracts needed = 100,000 / 5,000 = 20 contracts.
2. Farmer sells 20 wheat futures at $5.00 to lock a price.
3. At harvest, the farmer sells the physical wheat at the spot price $4.50 → cash revenue = 100,000 × $4.50 = $450,000.
4. The futures position: sold at $5.00 and bought back at $4.50 → futures gain = $0.50 × 100,000 = $50,000.
5. Net revenue = $450,000 (cash sale) + $50,000 (futures gain) = $500,000, which equals the locked-in price $5
.00 per bushel.
Common complementary examples and concepts
Long hedge (buyer hedging future purchase)
– Scenario: A flour mill expects to buy 100,000 bushels of wheat at harvest and fears prices will rise. It can enter a long futures position to lock in a purchase price.
– Exchange contract size: 5,000 bushels. Number of contracts = 100,000 / 5,000 = 20 contracts.
– If futures are bought at $5.00 and spot at delivery is $5.50, the mill pays $5.50 × 100,000 = $550,000 in the cash market but gains on futures: ($5.50 – $5.00) × 100,000 = $50,000. Net effective price = $550,000 – $50,000 = $500,000 → $5.00 per bushel, the locked price.
Basis and basis risk
– Basis: spot price − futures price for the same commodity and delivery month. It reflects transportation, storage, and local supply/demand differences.
– Basis risk: the risk that basis changes between the time you hedge and the time you offset the futures position. Even a correctly sized futures hedge can leave residual profit/loss if basis moves.
– Example: Farmer sells futures at $5.00. If at harvest spot = $4.80 and futures = $4.70, basis = $0.10 (spot − futures). The hedge result depends on both spot movement and basis change.
Hedge ratios and imperfect hedges
– Simple unit hedge: Number of contracts = quantity to hedge / contract size (used when contracts and exposure match exactly).
– Minimum-variance hedge ratio (h*): the fraction of exposure that minimizes variance when spot and futures returns are not perfectly correlated.
Formula: h* = ρ × (σ_S / σ_F)
– ρ = correlation coefficient between spot and futures price changes.
– σ_S = standard deviation (volatility) of spot price changes.
– σ_F = standard deviation of futures price changes.
– Example: A commodity user has exposure of 250,000 bushels and contract size 5,000 → 50 contracts if fully hedged. If ρ = 0.9, σ_S = 0.12 (12%), σ_F = 0.10 (10%): h* = 0.9 × (0.12/0.10) = 1.08 → cap at 1.00 (100% hedge). If h* were 0.85, number of contracts = 0.85 × 50 ≈ 42–43 (round to whole contracts).
Practical checklist for placing a futures hedge
1. Define exposure: quantity, timing, and price sensitivity.
2. Choose contract month(s) that best match your delivery or receipt period.
3. Calculate number of contracts:
– Unit hedge: quantity / contract size.
– Value hedge (if hedging dollar value): (exposure value) / (contract value).
– If using minimum-variance h*, adjust contracts by h*.
4. Confirm margin requirements and available liquidity with your broker or clearing member.
5. Enter the futures position (sell to hedge production; buy to hedge purchase requirement).
6. Monitor spot, futures, and basis; be prepared to close or roll positions as basis or timing changes.
7. At or near delivery/receipt, offset the futures position (or take/meet delivery if that is your intention).
8. Account for transaction costs, financing, taxes, and possible delivery/quality specifications.
Practical considerations and limitations
– Margin calls: Futures require posting initial margin and variation margin when losses occur; ensure liquidity for margin calls.
– Contract specs: Quality, delivery point, and contract month differences can create basis risk or require cross-hedging.
– Transaction costs: Commissions and bid-ask spreads reduce hedge effectiveness.
– Regulatory and tax issues: Different jurisdictions tax futures gains/losses differently.
– Cross-hedging: If no exact futures contract exists for your commodity, you may hedge with a related contract; correlation and basis become critical.
Worked numeric example — imperfect hedge with basis change
– Farmer hedged 100,000 bushels by selling 20 contracts at futures $5.00; spot at hedge = $5.05 → initial basis = $0.05.
– At harvest spot = $4.60 and corresponding futures = $4.55 → final basis = $0.05; basis unchanged:
– Cash sale = 100,000 × $4.60 = $460,000.
– Futures gain = ($5.00 − $4.55) × 100,000 = $45,000.
– Net = $505,000 → effective price $5.05 (initial spot price), showing price risk hedged and basis preserved.
– If basis widened: final spot = $4.60, futures = $4.40 → final basis = $0.20:
– Cash = $460,000.
– Futures gain = ($5.00 − $4.40) × 100,000 = $60,000.
– Net = $520,000 → effective price $5.20; result differs because basis moved.
Where to learn more (reputable sources)
– Investopedia — Commodity Definition and Examples: https://www.investopedia.com/terms/c/commodity.asp
– CME Group — Futures Products and Contract Specifications: https://www.cmegroup.com/markets/agriculture.html (replace agriculture path with relevant commodity area)
– U.S. Commodity Futures Trading Commission (CFTC) — “A Plain English Guide to Futures and Options”: https://www.cftc.gov/sites
– World Bank — Commodity Markets and Price Data: https://www.worldbank.org/en/research/commodity-markets
– U.S. Department of Agriculture (USDA) — Agricultural Marketing Service (Market News): https://www.ams.usda.gov/market-news
Quick hedger checklist (step-by-step)
1. Quantify exposure. Calculate the physical quantity or dollar value you need to hedge and the time window (e.g., 100,000 bushels to sell in 6 months).
2. Select the contract. Choose a futures contract that matches the commodity, delivery month, and contract size. Check tick value and contract multiplier.
3. Compute hedge size. Basic hedge: number of contracts = exposure / contract_size. If you target a hedge ratio (fraction hedged), multiply by that ratio. Round to whole contracts. Example: exposure = 250,000 bushels, contract_size = 5,000 bushels → 250,000 / 5,000 = 50 contracts. If hedge ratio = 0.9 → 50 × 0.9 = 45 contracts.
4. Estimate cash/futures P&L ranges. Use plausible price moves to compute worst-case margin calls and profit/loss scenarios. Include basis risk (difference between local cash price and futures price).
5. Check margin and financing. Confirm available liquidity for initial and variation margin to avoid forced liquidation.
6. Define exit/roll rules. Decide when to lift the hedge, roll to the next contract, or pass-through to physical market participants.
7. Monitor daily. Track basis, open interest (liquidity proxy), and margin requirements; be ready to adjust.
Worked numerical check (basis effect)
– Suppose you’re short 50 futures on a contract sized for 5,000 units (covers 250,000 units).
– Initial spot = $5.00, initial futures = $5.00 (basis = $0.00).
– If final spot = $4.60 and final futures = $4.40, cash proceeds = 250,000 × $4.60 = $1,150,000. Futures gain = (initial futures − final futures) × 250,000 = ($5.00 − $4.40) × 250,000 = $150,000. Net proceeds = $1,300,000 → effective price $5.20. The improvement over final spot shows the basis widened in your favor; if basis had moved opposite, your net would reflect that basis loss.
Common pitfalls (short list)
– Basis risk: local cash and futures prices can move differently.
– Liquidity mismatch: small or off‑season contracts can be illiquid.
– Rollover and carry costs: cost to move exposure between contract months.
– Margin calls: large intraday moves can create cash strain.
– Over- or under-hedging: rounding to whole contracts and imperfect correlations.
Where to learn more (official docs and specs)
– CME Group — Contract Specifications and Market Data: https://www.cmegroup.com/
– U.S. Commodity Futures Trading Commission (CFTC) — “A Plain English Guide to Futures and Options”: https://www.cftc.gov/sites/default/files/idc/groups/public/@customerprotection/documents/file/futuresoptionsguide.pdf
Educational disclaimer
This information is educational and not individualized investment advice. Futures and commodity trading involve significant risk, including margin requirements and potential for loss
…including margin requirements and potential for loss.
Practical checklist for traders and hedgers
– Confirm contract specs: underlying unit, contract size, tick value, delivery months, last trading day. (Source: exchange contract specs.)
– Match exposure to contract: choose a contract whose underlying commodity, quality and delivery location best aligns with your physical exposure or investment thesis.
– Calculate contracts: number of contracts = exposure quantity / contract size (round to whole contracts). Note over‑/under‑hedging risk when you must round.
– Check liquidity and spreads: prefer front‑month contracts with narrow bid/ask spreads; examine open interest and volume.
– Estimate margin and cash needs: initial margin × number of contracts = initial cash required; plan for maintenance margin and potential intraday margin calls.
– Study historical basis: analyze how local cash price minus futures price (basis) has behaved in your region and season.
– Plan rollovers: if you need continuous exposure, quantify expected rollover costs (difference between near and next futures prices) and timing.
– Manage operational risks: keep records, set stop rules, and confirm broker and exchange operational hours and rules.
Worked numeric examples
1) Calculating number of contracts (simple hedge)
– Situation: A soybean farmer expects to sell 120,000 bushels in November. A standard CME soybean futures contract = 5,000 bushels.
– Calculation: 120,000 / 5,000 = 24 contracts.
– Action: Short 24 contracts to hedge the expected crop. If you must round, consider the price risk on the remaining unhedged quantity.
2) Hedge effectiveness and basis example
– Definitions: basis = cash price − futures price. A short hedger (producer) locks price on futures; realized effective price = cash sale price + (futures short entry − futures exit).
– Example numbers:
– Initial futures when hedge established = $4.30/bu.
– Initial cash price = $4.20/bu → initial basis = 4.20 − 4
= continued example (hedge effectiveness and basis) =
Initial basis = cash price − futures price = 4.20 − 4.30 = −0.10 $/bu (i.e., cash is $0.10/bu weaker than futures).
Now suppose at harvest/sale time futures have fallen to 4.00 $/bu and the farmer sells the cash crop for 3.90 $/bu. Compute outcomes:
– Futures P&L on the short hedge = short entry − short exit = 4.30 − 4.00 = 0.30 $/bu (gain).
– Cash sale price = 3.90 $/bu.
– Realized effective price = cash sale price + futures P&L = 3.90 + 0.30 = 4.20 $/bu.
Notice the realized effective price (4.20) equals the initial cash price before the hedge (4.20). That reflects a hedge that offset the price decline in both cash and futures when the basis stayed the same (initial basis −0.10 → final basis −0.10). The hedge successfully locked in the producer’s expected price, aside from transaction costs and margins.
Alternate scenario: basis changes
– If at sale futures = 4.00 $/bu but cash = 4.05 $/bu, final basis = 4.05 − 4.00 = +0.05 $/bu (basis improved by $0.15). Futures P&L remains 0.30, so realized = 4.05 + 0.30 = 4.35 $/bu — the hedger is better off because the basis strengthened.
– If cash = 3.75 $/bu when futures = 4.00 $/bu, final basis = 3.75 − 4.00 = −0.25 $/bu (basis weakened by $0.15). Realized = 3.75 + 0.30 = 4.05 $/bu — the hedger receives less than the expected 4.20 because basis moved against them.
Key formulas (short hedger / producer)
– Basis = cash price − futures price.
– Number of contracts = exposure quantity / contract size (round as needed).
– Futures P&L (short) per unit = futures entry − futures exit.
– Realized effective price = cash sale price + (futures entry − futures exit).
For a long hedger (e.g., processor hedging a future purchase) the realized effective purchase price is analogous but uses the long futures P&L: realized effective price = cash purchase price − (futures exit − futures entry).
Practical checklist to set up a simple futures hedge
1. Quantify exposure (units, delivery month).
2. Choose the appropriate futures contract (contract size and month).
3. Calculate number of contracts = exposure / contract size; decide rounding and residual exposure plan.
4. Record initial cash and futures prices; compute initial basis.
5. Enter futures position (short if you are a producer; long if you are a buyer).
6. Monitor margin requirements, storage and cash market conditions.
7. Close futures position near sale/purchase date; record cash sale/purchase price and futures exit price.
8. Compute realized effective price and compare to target; review basis behavior and costs.
Assumptions and caveats
– Examples ignore transaction costs, commissions, financing or storage costs, and margin funding.
– Hedging transfers market price risk but introduces basis risk (the risk that basis moves).
– Physical delivery procedures, quality adjustments and grade differentials may affect the cash price.
– Rounding to whole contracts leaves residual unhedged exposure that must be managed separately.
Further reading
– Investopedia — Commodity: https://www.investopedia.com/terms/c/commodity.asp
– CME Group — Soybeans Contract Specifications: https://www.cmegroup.com/trading/agricultural/grain-and-oilseed/soybeans_contract_specifications.html
– CME Group — Hedging Basics (education): https://www.cme
Group — Hedging Basics (education): https://www.cmegroup.com/education/courses/hedging-basics.html
– CFTC — A Primer on Futures Markets (backgrounder): https://www.cftc.gov/sites/default/files/files/idc/groups/public/@newsroom/documents/file/futures_primer.pdf
– USDA Economic Research Service — Commodity Markets and Trade (overview and data): https://www.ers.usda.gov/topics/commodity-markets/
Educational disclaimer: This information is for educational purposes only and does not constitute individualized investment advice.