Commodity Trading: Analysis of key factors
Agriculture commodity markets are analyzed either technically or fundamentally. Fundamental analysis studies supply and demand relationships that define the price of a commodity at any given time. Read how demand and supply determine market price.
Technical analysis uses specialized methods of predicting prices by analyzing past price patterns and levels. While this has been described as driving a car using only the rear view mirror, its wide acceptance by traders makes it a credible technique. Traders predict when price trends will change and how high or low prices will move by charting prices (usually futures) and looking for repeating patterns.
Both fundamental and technical analysis are used to study commodity markets. Fundamentals, or supply/demand factors, tend to provide underlying reason to the market. Technical analysis is used to provide an indication of price trend, and an estimate of the timing and magnitude of price change. Of the two, fundamentals are the stronger force. However, because so many market participants follow technical indicators, response to those indicators can affect a market dramatically.
Supply and demand ultimately determine commodity prices. There is an equilibrium or “market-clearing” price at which the quantity producers supply to the market equals the quantity buyers are willing to take. Demand and supply are balanced at price PE.
One of the functions of futures markets is to discover an “equilibrium price” for a future time period. However, supply and demand levels are not known with certainty months or even years into the future. Futures prices vary across a wide range, as estimates of supply and demand are adjusted for changes in weather, economic conditions in Asia that will influence export buying, or changes in the U.S. dollar that influence the cost of U.S. commodities.
Over time, a chart of prices for cotton futures or for live cattle (the fed cattle futures) will show patterns as the price discovery process responds to actual or perceived changes in supply and/or demand. The study of those chart patterns is called technical analysis. Such analysis is based on the notion that price and price patterns in the past are useful in forming expectations about what price will do in the future. Technical analysis is especially useful in determining when to enter and exit the markets in programs designed to manage a firm’s exposure to price risk.
Technical analysis can be complex. Sophisticated mathematical models can be used to help identify changes in the direction of price trend. Econometric models are used by large hedgers and full-time speculators looking for a competitive edge. But when used with discipline, some simple and basic techniques can make big contributions to price risk management programs.
Understanding Commodities
The basic idea is that there is little differentiation between a commodity coming from one producer and the same commodity from another producer. A barrel of oil is basically the same product, regardless of the producer. By contrast, for electronics merchandise, the quality and features of a given product may be completely different depending on the producer.
Some traditional examples of commodities include grains, gold, beef, oil, and natural gas. More recently, the definition has expanded to include financial products, such as foreign currencies and indexes. Technological advances have also led to new types of commodities being exchanged in the marketplace. For example, cell phone minutes and bandwidth.
Types of Commodity Buyers
There are two key types of commodity buyers, transactions between buyers and producers, and speculators.
Buyer and Producers
The sale and purchase of commodities are usually carried out through futures contracts on exchanges that standardize the quantity and minimum quality of the commodity being traded. For example, the Chicago Board of Trade (CBOT) stipulates that one wheat contract is for 5,000 bushels and states what grades of wheat can be used to satisfy the contract.1
Two types of traders trade commodity futures. The first are buyers and producers of commodities that use commodity futures contracts for the hedging purposes for which they were originally intended. These traders make or take delivery of the actual commodity when the futures contract expires.
For example, the wheat farmer that plants a crop can hedge against the risk of losing money if the price of wheat falls before the crop is harvested. The farmer can sell wheat futures contracts when the crop is planted and guarantee a predetermined price for the wheat at the time it is harvested.
Commodities Speculators
The second type of commodities trader is the speculator. These are traders who trade in the commodities markets for the sole purpose of profiting from the volatile price movements. These traders never intend to make or take delivery of the actual commodity when the futures contract expires.
Many of the futures markets are very liquid and have a high degree of daily range and volatility, making them very tempting markets for intraday traders. Many of the index futures are used by brokerages and portfolio managers to offset risk. Also, since commodities do not typically trade in tandem with equity and bond markets, some commodities can be used effectively to diversify an investment portfolio.
What Are Some Commodity Examples?
Commodities are basic goods and materials that are widely used and are not meaningfully differentiated from one another. Examples of commodities include barrels of oils, bushels of wheat, or megawatt-hours of electricity. Commodities have long been an important part of commerce, but in recent decades the trading of commodities has become increasingly standardized.
What Is the Relationship Between Commodities and Derivatives?
The modern commodities market relies heavily on derivative securities, such as futures contracts and forward contracts. Buyers and sellers can transact with one another easily and in large volumes without needing to exchange the physical commodities themselves. Many buyers and sellers of commodity derivatives do so to speculate on the price movements of the underlying commodities for purposes such as risk hedging and inflation protection.