What Are Commodity Derivatives Markets?

Mary McMahon
Mary McMahon

Commodity derivatives markets provide a medium for exchanging financial products based on commodities like grain, oil, and metals. Rather than trading directly in commodities, participants exchange contracts for the sale and delivery of certain products. They speculate on future pricing to buy and sell contracts, and do not handle the commodities themselves. Such markets can be found in a number of nations to provide a mechanism for traders to freely exchange contracts and funds. The level of regulation and oversight available can vary by nation.

Traders active in commodity derivatives markets need to track prices.
Traders active in commodity derivatives markets need to track prices.

Some examples of commodity derivatives can include contracts to buy a commodity at a set price on a given date, which can allow people to take advantage of price fluctuations. If the price is lower than market value, the holder of the contract can buy up the commodity and then resell it at a higher price. Sales contracts, offering the right to sell at a given value, also are also available, along with more complex derivatives. In commodity derivatives markets, traders have an opportunity to handle a variety of contracts.

These contracts were originally designed to provide protection and assurance to farmers. A farmer setting a crop wanted to be assured of getting a specific price for it on market day, and also wanted a guarantee that there would be a buyer. Buyers, in turn, wanted to lock in pricing early to allow themselves to get in position in the market. Over time, the practice of trading on commodity derivatives markets spread to other commodities, and to traders not directly involved in the handling of these products.

Traders active in commodity derivatives markets need to track prices to decide when and where to handle contracts, and whether they should buy, sell, or hold. A given contract may change hands multiple times before it matures as traders adjust their positions in the market. Some traders represent themselves, trading contracts for their own profit, while others may work for brokerages and can represent employers or clients. This involves careful analysis to make the best decisions for the given situation, considering the risks and benefits of available trades.

Regulators may watch commodity derivatives markets. Brisk trade in derivatives can have an impact on commodity pricing, which can be a cause for concern, and as with other financial markets, a snowball effect can occur. If traders get nervous and begin selling off contracts, for example, a rapid fall in price could be triggered and it might take months to recover. Markets may also be monitored for signs of insider trading or other inappropriate activities.

Mary McMahon
Mary McMahon

Ever since she began contributing to the site several years ago, Mary has embraced the exciting challenge of being a wiseGEEK researcher and writer. Mary has a liberal arts degree from Goddard College and spends her free time reading, cooking, and exploring the great outdoors.

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