Content

Introduction

Chapter I: Understanding Commodity Market and

Commodities Exchange

Chapter II: Commodity Trading. Commodities

Exchange on Crude Oil

Conclusion

References
 Introduction
A commodity market is a marketplace for buying, selling, and trading raw
materials or primary products.

Commodities are often split into two broad categories: hard and soft
commodities. Hard commodities include natural resources that must be mined
or extracted - such as gold, rubber, and oil, whereas soft commodities are
agricultural products or livestock—such as corn, wheat, coffee, sugar,
soybeans, and pork.

A commodities exchange is a legal entity that determines and enforces rules and
procedures for trading standardized commodity contracts and related
investment products. A commodities exchange also refers to the physical center
where trading takes place. The commodities market is massive, trading more
than trillions of dollars each day.Traders rarely deliver any physical
commodities through a commodities exchange. Instead, they trade futures
contracts, where the parties agree to buy or sell a specific amount of the
commodity at an agreed upon price, regardless of what it currently trades at in
the market at a a predetermined expiration date.

The most traded commodity future contract is crude oil. There are several types
of modern commodities exchanges, which include metals, fuels, and
agricultural commodities exchanges.
 Chapter I: Understanding Commodity Market and
Commodities Exchange

Commodities markets allow producers and consumers of commodity products

to gain access to them in a centralized and liquid marketplace. These market
actors can also use commodities derivatives to hedge future consumption or
production. Speculators, investors, and arbitrageurs also play an active role in
these markets.

Certain commodities, such as precious metals, have been thought of to be a

good hedge against inflation, and a broad set of commodities as an alternative
asset class can help diversify a portfolio. Because the prices of commodities
tend to move in opposition to stocks, some investors also rely on commodities
during periods of market volatility.

In the past, commodities trading required significant amounts of time, money,

and expertise, and was primarily limited to professional traders. Today, there
are more options for participating in the commodity markets.

History of Commodity Markets

Trading commodities goes back to the dawn of human civilization as tribal
clans and newly established kingdoms would barter and trade with one another
for food, supplies, and other items. Trading commodities indeed predates that of
stocks and bonds by many centuries. The rise of empires such as ancient Greece
and Rome can be directly linked to their ability to create complex trading
systems and facilitate the exchange of commodities across vast swaths via
routes like the famous Silk Road that linked Europe to the Far East.

Today, commodities are still exchanged throughout the world and on a massive
scale. Things have also become more sophisticated with the advent of
exchanges and derivatives markets, Exchanges regulate and standardized
commodity trading, allowing for liquid and efficient markets.

Types of Commodity Markets

Generally speaking, commodities trade either in spot markets or derivatives
markets. Spot markets are also referred to as “physical markets” or “cash
markets” where buyers and sellers exchange physical commodities for
immediate delivery.

Derivatives markets involve forwards, futures, and options. Forwards and

futures are derivatives contracts that use the spot market as the underlying asset.
These are contracts that give the owner control of the underlying at some point
in the future, for a price agreed upon today. Only when the contracts expire
would physical delivery of the commodity or other asset take place, and often
traders will roll over or close out their contracts in order to avoid making or
taking delivery altogether. Forwards and futures are generically the same,
except that forwards are customizable and trade over-the-counter (OTC),
whereas futures are standardized and traded on exchanges.

Commodities exchanges are the central location where commodities are traded.
The commodity markets began with the trading of agricultural products such as
corn, cattle, wheat, and pigs in the 19th century. Chicago was the main hub for
this kind of trading, due to its geographical location near the farm belt and
because it was a key east-west transit point with railroad access. Modern
commodity markets trade many types of investment vehicles, and are often
utilized by various investors from commodity producers to investment
speculators.

Two of the best known commodity exchanges in the United States are
the Chicago Mercantile Exchange (CME) Group and the New York Mercantile
Exchange (NYMEX). CME Group is the world's leading and most diverse
derivatives marketplace, handling three billion contracts worth approximately
$1 quadrillion annually, while the NYMEX is one part of the CME Group.

The most well-known commodity exchange in Europe is the Intercontinental

Exchange (ICE). Similar to CME and NYMEX, ICE is an electronic
commodity exchange with no physical trading floor. In a cost competitive
environment, electronic exchanges are becoming more prevalent. The only
physical commodity trading exchange left in Europe is the London Metal
Exchange (LME). The LME is the world center for the trading of industrial
metals—more than three quarters of all non-ferrous metal futures business is
transacted there.

Limitations of Commodities Exchanges

The nature of commodities exchanges is changing rapidly. The trend is in the
direction of electronic trading and away from traditional open outcry trading,
where traders meet face-to-face and trade in what is known as a trading pit.
With the open outcry system, traders communicate buy and sell orders through
hand and verbal signals, just like an auction.

For example, in July 2016, CME Group closed down the NYMEX commodities
trading floor, the last of its kind, after all but 0.3% of its energy and metals
volumes shifted to computers. A year earlier, CME decided to shut down the
 commodity trading floor in Chicago, ending a 167-year-old tradition of face-to-
face trading in favor of fully electronic trading.

Types of Commodities
Commodities are raw materials that are used to produce finished goods.
Commodities include agricultural products, mineral ores and fossil fuels—
they’re basically any kind of natural resource that is consumed by companies
and individuals. Commodities are physical goods that are bought, sold and
traded in markets, distinct from securities such as stocks and bonds that exist
only as financial contracts.

There are four main types of commodities:

 Energy. The energy market includes oil, natural gas, coal and ethanol—even
uranium. Energy also includes forms of renewable energy, like wind power and
solar power.
 Metals. Commodity metals include precious metals, like gold, silver, palladium
and platinum, as well as industrial metals, like iron ore, tin, copper, aluminum
and zinc.
 Agriculture. Agriculture covers edible goods, such as cocoa, grain, sugar and
wheat, as well as nonedible products, such as cotton, palm oil and rubber.
 Livestock. Livestock includes all live animals, such as cattle and hogs.
Commodities prices shift constantly as supply and demand change in a single
economy and around the world. A bad harvest in India could lead to higher
grain prices while climbing oil production in the Middle East could depress the
global price of oil.

Investors in the commodity market aim to profit from supply and demand
trends or reduce risk through diversification by adding different asset classes to
their portfolios.
A commodity is a basic good that is interchangeable with other commodities of
the same type. They are generally used in the production of goods and services.

We may not realize it, but commodities have a very important place in our
everyday lives. Consider the cotton that makes up your clothing, the lumber that
makes up the frame of your home, or even the metal in your electronics.

The following is a list of some of the most traded commodities in the world.

 Crude Oil: One of the most important commodities in the world, crude

oil is an unrefined petroleum product that occurs naturally. It is used to
produce different products including gasoline and petrochemicals. The
price for crude oil generally reported in the U.S. is based on the NYMEX
futures price. Contracts are based on 1,000 barrels and trade in U.S.
dollars per barrel. The third business day before the 25th calendar day of
the month preceding the delivery month is the last trading day for crude
oil.
 Gold: This is one of the world's most widely-traded precious metals.
While investors can buy and sell the physical commodities, traders
typically trade gold futures contracts on commodities exchanges.
Contracts are generally sized at 100 troy ounces, and are priced in U.S.
dollars per troy ounce. The last trading day for gold is the third last
business day of the delivery month.
 Lumber: This industry has two main products for the end user—
softwood and hardwood. Softwood is used primarily in construction,
while hardwood is used in flooring and furniture construction, and to
make panels and cabinets. Contract sizes for lumber are generally
110,000 nominal board feet and are traded in U.S. dollars per pound. The
 business day immediately preceding the 16th calendar day of the contract
month is the last trading day for lumber.
 Natural Gas: This commodity is used to heat homes, help generate
electricity, and also has other uses in the commercial and industrial
industries. Natural gas contracts are sold by 10,000 million British
thermal units (mmBtu). All contracts are traded in U.S. dollars per
mmBtu. The final trading day of the month for natural gas is three
business days prior to the first day of the delivery month.
 Cotton: Cotton is the most widely-used fiber in the world. Cotton fibers
are collected and made into yarn and other textiles for clothing and other
household goods. Cotton contracts are sized at 50,000 pounds, and trade
in U.S. dollars per pound. The very last day of trading for cotton is 17
business days from end of spot month.

Other commodities that trade on commodities exchanges include silver,

platinum, rice, sugar, orange juice, oats, cattle, corn, copper, cocoa, soybeans,
and coffee. This, however, is not an exhaustive list of what you can find on an
exchange.

Most historians are of the opinion that the use of gold coins as a medium of
exchange in medieval Europe played a crucial role in the development of
markets for trading commodities. Initially, these coins were traded with the
merchants from the East Indies and Asia. Later, the need was felt for centralized
exchanges.

There are four main participants in a commodity exchange:

Producers
These supply the commodities for trade. Without them, there will be no
commodity to trade, and thus, no need for an exchange. Producers are usually
oil and gas companies, farmers, mining companies and cattle ranchers.

End-users

These could be individuals and companies and help to build a demand for a
commodity. For instance, the end-users could be companies using the
commodities in their production processes, such as cloth makers, food
manufacturers and more.

Speculators

These are the traders that bet on the movement of the commodities prices. They
often serve as a liquidity source for producers and the end-users as well.

Traders

They serve as an intermediary between the producers and the end-users. At

times of market imbalances, they help to provide liquidity. For example, if a
producer has an excess inventory and there are no end-users to buy it. Then,
traders may buy this inventory to restore the prices.

Commodity Contract Features

Each contract has the following standard feature:

Quantity  

Generally refers to the quantity of the commodity stated in the contract. It can
be either in the metric unit or traditional units such as a bag or barrel or the
imperial unit.
Price

The price of the contract is determined through fair price discovery between the
buyer and the seller. Exchanges, usually, do not play any role in the price
determination unless there is some dispute.

Quality

It is not that relevant usually. Quality refers to the specifications of the

commodity such as the commodity might be from a specific region and so on.

Delivery

Exchange decides the delivery date of each contract along with the method and
place. There would be some contracts that are settled through financial
payments rather than physical delivery.

Functions of a Commodity Exchange

 To serve as a platform for a different type of investors for buying and

selling the commodities through fair price discovery.
 To acquire and disseminate the commodity news, in order, to help traders
in making decisions.
 Exchanges also help in settling the disputes between the traders.
 Exchanges are also responsible for grading the commodities available for
trade. This allows dealers and other parties to enter into an agreement
quickly.
Advantage of Commodity exchange

 It gives an option to the investors and traders to transfer their risk to

professional risk bearers.
  Exchanges offer a continuous and fair market for the price
discovery wherein the producer of the commodity is free from
middlemen.
 Since the commodity exchanges ensure the continuity of trade, financiers
and bankers have no issues to extend a loan against the commodities.
 Commodity exchanges offer hedging opportunities. This helps to reduce
the effect of fluctuation in the price.
Disadvantages

Leverage – margin requisites by the exchanges are kept low, thereby, causing
poor money management. This sometimes leads to unnecessary risk-taking.
Physical Delivery – traders don’t prefer the physical delivery of the
commodities because they cannot afford to take deliveries of huge quantities of
commodities.
A Risky Business – matching the speed of the bots and Algo trading is always
a risky business with many traders burning their hands due to either greed or
fear.
 Chapter II: Commodity Trading. Commodities
Exchange on Crude Oil
What is Commodity Trading?

Commodity trading is the exchange of different assets, typically futures

contracts, that are based on the price of an underlying physical commodity.
With the buying or selling of these futures contracts, investors make bets on the
expected future value of a given commodity. If they think the price of a
commodity will go up, they buy certain futures—or go long—and if they think
price the commodity will fall, they sell off other futures—or go short.

Given the importance of commodities in daily life, commodity trading began

long before modern financial markets evolved as ancient empires developed
trade routes for exchanging their goods.

“Commodities trading is properly the birth of modern investing—the ceiling of

the New York Stock Exchange is adorned with gold tobacco leaves in homage
to the commodity trading that gave birth to the institution,” says Giannotto.

Modern commodity trading in the United States started in 1848 at the Chicago
Board of Trade. It allowed farmers to lock in sales prices for their grain at
different points during the year rather than only at harvest, when prices tended
to be low. By agreeing to a price ahead of time through futures contracts, both
the farmer and the buyer gained protection against price changes.

Today, the commodities market is much more sophisticated. Not only is there a
long list of varied commodities being traded, but it’s also an international
market with exchanges around the world. You can trade commodities nearly 24
hours a day during the workweek.

How to Trade Commodities?

There are a few different ways to trade commodities in your portfolio, with
their own advantages and disadvantages.

Commodities Futures

The most common way to trade commodities is to buy and sell contracts on a
futures exchange. The way this works is you enter into an agreement with
another investor based on the future price of a commodity.

For example, you might agree to a commodity future contract to buy 10,000
barrels of oil at $45 a barrel in 30 days. At the end of the contract, you don’t
transfer the physical goods, but you close out your contract by taking an
opposite position through the spot trading market. So in this example, when the
futures contract reaches its expiration date, you would close out the position by
entering another contract to sell 10,000 barrels of oil at the current market price.

If the spot price ends up higher than your contract’s price of $45 a barrel, you
would make a profit, and if it’s lower, you would lose money. On the other
hand, if you had entered a futures contract to sell oil, you would make money
when the spot price goes down, and you would lose money when the spot price
goes up. At any point, you could close out your position before the contract
expiration date.

To invest in futures trading, you need to set up an account with a

specialty brokerage account that offers these types of trades.

“Traders can access these markets by having an account with a brokerage firm
that offers futures and options,” says Craig Turner, senior commodities broker
with Daniels Trading in Chicago. You will owe a commodity futures trading
commission each time you open or close a position.

Physical Commodity Purchases

When you trade futures contracts, you’re not buying or selling the physical
commodity itself. Futures traders don’t actually take delivery of millions of
barrels of oil or herds of live cattle—futures are all about betting on price
changes only. However, for precious metals like gold and silver, individual
investors can and do take possession of the physical goods themselves, like
gold bars, coins or jewelry.

These investments give you exposure to commodity gold, silver and other
precious metals and let you feel the actual weight of your investments. But with
precious metals, transaction costs are higher than other investments.

This strategy is only practical for value-dense commodities, such as gold, silver
or platinum. Even then, investors will pay high markups over spot price on the
retail market.

Commodities Stocks
Another option is to buy the stock of a company involved with a commodity.
For oil, you could buy the stock of an oil refining or drilling company; for
grain, you could buy into a large agriculture business or one that sells seeds.

These sorts of stock investments follow the price of the underlying commodity.
If oil prices go up, an oil company should be more profitable so its share price
would go up, too.

Investing in commodity stocks has less risk than investing directly in

commodities because you aren’t just betting on the commodity price. A well-
run company could still make money even if the commodity itself falls in value.
But this goes both ways. While higher oil prices could help an oil company’s
stock price, there are other factors as well, like their company management and
total market share. If you are looking for an investment that perfectly tracks a
commodity price, buying stocks is not an exact match.

Commodities ETFs, Mutual Funds and ETNs

There are also mutual funds, exchange traded funds (ETFs) and exchange
traded notes (ETNs) that are based on commodities. These funds combine the
money from many small investors to build a large portfolio that tries to track
the price of a commodity or a basket of commodities—for example, an energy
mutual fund based on multiple energy commodities. The fund may buy futures
contracts to track the price, or it might invest in the stock of different companies
with commodity exposure.

Commodity ETFs truly democratized the commodities trading game to all

investors—they are low cost, readily accessible and highly liquid.

With a small investment, you can gain access to a much larger range of
commodities than if you tried to build the portfolio yourself. Plus, you’ll have a
professional investor managing the portfolio. However, you’ll need to pay an
additional management fee to the commodity fund over what it might cost if
you had made the investments yourself. In addition, depending on the fund’s
approach, it may not perfectly track the commodity price.

Commodity Pools and Managed Futures

Commodity pools and managed futures are private funds that can invest in
commodities. They are like mutual funds except many of them are not publicly
traded, so you need to be approved to buy into the fund.

These funds can use more complex trading strategies than ETFs and mutual
funds so they have the potential for higher returns. In exchange, the
management costs may also be higher.

Commodity vs Stock Trading

With commodity trading, using leverage is much more common than with stock
trading. This means you only put down a percentage of the needed money for
an investment. For example, rather than putting down the full $75,000 for the
full value of an oil futures contract, you might put down 10% or $7,500.

The contract will require you to keep a minimum balance based on the expected
value of your trade. If the market price starts moving in a direction where you
are more likely to lose money, you would face a margin call and need to deposit
more to get back to the trade’s required minimum value.

“Trading on margin can lead to greater returns than the stock market, but it can
also lead to greater losses due to the leverage used,” says Turner. Small price
moves lead to big changes for your investment return, meaning your potential
for gain in the commodity market is high but so is your potential for losses.
Commodities also tend to be a short-term investment, especially if you enter a
futures contract with a set deadline. This is in contrast to stocks and other
market assets where buying and holding assets long term is more common.

In addition, you have more time to make trades with commodities because
markets are open nearly 24/7. With stocks you primarily make trades during
normal business hours, when the stock exchanges are open. You may have
limited early access through premarket futures, but most stock trading occurs
during normal business hours.

Overall, commodity trading tends to be more high-risk and speculative than

stock trading, but it can also lead to faster, larger gains if your positions end up
making money.

Commodities Exchange on Crude oil

Crude oil is a naturally occurring, unrefined petroleum product composed of
hydrocarbon deposits in natural underground pools or reservoirs and remains
liquid at atmospheric pressure and temperature. Although it is often called
"black gold," crude oil has a wide ranging viscosity and can vary in colour to
various shades of black and yellow depending on its hydrocarbon composition.
Crude oil can be refined to produce usable products such as gasoline, diesel and
various forms of petrochemicals.

Even though most crude oil is produced by a relatively small number of

companies, and often located in remote locations far from the point of
consumption, trading in crude oil on a global basis has always been robust.
Nearly 80% of international crude oil is transported through waterways in large
tankers and most of the rest by inland pipelines
The majority of oil reserves in the world is in the Middle East, at 48 per cent of
the known and identified reserves. This is followed by North America, Africa,
Central and South America, Eurasia, Asia and Oceania, and Europe.
OPEC controls almost 40 per cent of the world's crude oil, accounts for about
75 per cent of the world's proven oil reserves, and exports 55 per cent of the oil
traded internationally.

In oil trading, risk management techniques are extremely important for the
various stakeholders and participants, such as producers, exporters, marketers,
processors, and SMEs. Modern techniques and strategies, including market-
based risk management financial instruments like Crude Oil Futures, offered on
the MCX platform can improve efficiencies and consolidate competitiveness
through price risk management.

For many years, West Texas Intermediate (WTI) crude oil, a light, sweet crude
oil, was the world's most-traded commodity. WTI is a grade used as
a benchmark in oil pricing. It is the underlying commodity of Chicago
Mercantile Exchange's oil futures contracts. WTI is often referenced in news
reports on oil prices, alongside Brent Crude. WTI is lighter and sweeter than
Brent and considerably lighter and sweeter than Dubai or Oman.

From April through October 2012, Brent futures contracts exceeded those for
WTI, the longest streak since at least 1995.

Crude oil can be light or heavy. Oil was the first form of energy to be widely
traded. Some commodity market speculation is directly related to the stability
of certain states, e.g., Iraq, Bahrain, Iran, Venezuela and many others. Most
commodities markets are not so tied to the politics of volatile regions.
 Conclusion
Commodity investing is a strategy that’s best for sophisticated investors. Before
making any trades, you need to carefully understand the commodity price charts
and other forms of research. Since market price moves can lead to large gains
and losses, you need a high risk tolerance as well, meaning you can stomach
short-term losses in pursuit of long-term gains. And if you do invest in
commodities, it should only be a portion of your total portfolio.

For investors and traders who are looking to diversify their portfolio in an asset
class that offers a higher risk/reward profile, many use about 20% or less of
their portfolio for higher risk/reward. That is the segment where commodity
trading lives.

Like with any decision, consider speaking with a financial advisor to see if
investing in commodities is right for you and to get help on which strategies
you should use.

Many criticize speculators and traders in the commodities exchanges for driving
up the prices of the food, gasoline or other commodities. In reality, no
speculator can affect the price of commodities. And, even if they do it
somehow, the markets react very quickly to correct any imbalance.

References

https://efinancemanagement.com/investment-decisions/commodity-
exchange

https://en.wikipedia.org/wiki/Commodity_market

 "Soft Commodity Definition". Investopedia

"Variations of commodities in trading". GOptions Trading. 

Markham, Jerry W. (1987). The History of Commodity Futures Trading and Its

Regulation

McGowan, Michael (2011). "The rise of computerized high frequency trading:

use and controversy"

Johnson, David. "Stock Market Goes Decimal: Complicated fractions

abandoned in favor of pennies"