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Commodity investing is the process of entering into an agreement to buy or sell physical commodities, financial instruments, and currencies. The contract can be for the purchase of either a futures contract or an option on futures. Both are standardized and legally binding contracts that call for the delivery of the commodity at a specified date, price, and time.
Commodity futures are traded on the floor of commodity exchanges mostly in the United States, London, and Japan. All futures exchanges have clearing houses that guarantee that all trades are completed according to market rules and regulations. When a trade is made, the clearing house's role is to step in and function as the buyer or seller on both sides of the trade. Commodity exchanges are regulated by the government. In the United States, the regulatory body is the Commodity Futures Trading Commission.
Commodity markets were initially established as a system for commodity producers, such as agriculture and livestock farmers, to exercise some measure of control over price volatility in their respective businesses. Commodity markets allow producers to secure a price for their product for when the commodities are brought to market. This helps reduce their risk if prices were to undergo an unpredictable decline.
Trades are executed using electronic trading platforms and through the open outcry method. Only brokers and companies that are exchange members are permitted to trade on the exchange floor. Exchange members are usually licensed brokers who are paid fees and commissions to make trades on the behalf of clients. Exchange members may also trade for their personal accounts.
Unlike stock trading, investors in commodity investing are encourage to trade both the long side and short side of commodities. Some traders employ a strategy called a "spread" that entails doing both. By buying one contract and selling a related one, these investors hope to profit on the price difference.
A buyer who goes long is anticipating prices to rise. If prices increase, the investor will make a profit, but if prices fall, the buyer will suffer a loss. In contrast, buyers who buy short are expecting prices to decline. If they are correct they will make money. If instead prices increase, the buyer will lose on the investment.
There are basically two types of buyers in commodity investing: hedgers and speculators. Hedgers are individuals or businesses that purchase futures contracts to insure them against the unpredictability of market prices. Large trucking operations and airlines are typically hedgers in the oil futures market. These traders are not profit-oriented; their primary is to neutralize their risk.
Hedgers will then usually go into the cash, or spot market, to buy the same quantity of contracts, but taking the opposite position. The spot market is where goods are sold for cash and must be delivered immediately. This strategy, which is very common, reduces the effect of any erratic price movement. A hedger who goes long in futures will hedge short in the cash market. If he hedges short in the futures market, he will go long in the spot market.
Speculators who engage in commodity investing buy futures strictly for the purpose of making a profit. Whether prices are rising or declining is of little importance to them. Their focus is on successfully anticipating the direction of price movement. If they are correct, they stand to gain a sizable profit, often in a short period of time. Speculators whose analysis of the market is incorrect can lose a large amount of money just as quickly.