Rice. Corn. Coffee. Orange juice. While that may look like part of someone’s grocery list, those terms hold a much deeper meaning for those involved in commodity trading. Many investors carefully follow commodity prices on the market and are able to use some of the most common commodities in the world as effective ways of diversifying their financial portfolio.
First, though, if you are interested in commodity trading, you have likely realized that there is a lot of information to take in. With the vast amounts of information needing to be analyzed, including daily market reports, market forecasts, and quotes and bids, it can seem overwhelming to keep up.
That is where DTN ProphetX comes into play. Using this gold-standard data management system, you have the real-time data and high-level analysis you need to stay ahead of your competitors and on top of a market that never sleeps.
If you are looking into getting started with commodity trading, you may have noticed that commodity prices aren’t always as straightforward as you might think. This article will look at the two different types of commodity prices and what they can indicate about the market. Understanding these concepts will prove essential to getting started with commodity trading.
Futures prices vs spot prices explained
When looking into commodity prices, you may notice that there are multiple prices available: the spot price, and the futures price, for the commodity. What do those prices represent?
As the name suggests, “futures prices” refers to the price of a commodity for a future date. Buyers can lock in a price for a certain commodity for delivery at a specific time in the future, for example, one month or two months ahead, according to the expiration months of the contracts available. Some examples of futures markets are the New York Mercantile Exchange and the Chicago Mercantile Exchange.
Buyers use this method (futures contracts) in an effort to lock in a price that is hopefully lower than the current price. For sellers, there is an advantage because they have a guaranteed sale of the product in advance – at times, even before the commodity is ready. US Futures trading is regulated by the Commodity Futures Trading Commission, with a list of regulations that all traders must follow.
But investors using the futures market are generally not expecting to take possession of the commodity at the contract date. In that case, an investor can sell their position before the contract’s expiration to be free from the obligation of delivery. Or, depending on the commodity, a contract may be able to be cash-settled instead of requiring physical delivery. This contract fulfillment is especially helpful when working with huge quantities of commodities – for example, one contract for corn at CME is for 5000 bushels which is equal to 127 metric tons!
Using “options” is another way to use the futures market for a lower risk. Instead of requiring the sale or purchase of the commodity on the contract’s expiration date, options give the right, but not the necessity, to carry out the contract at expiration. Of course, for that freedom and lower risk, there is an up-front premium cost that affects the profitability of the trade in the end.
On the other hand, spot prices refer to the price of a commodity right now, or “on the spot.” Spot contracts are for immediate sale and possession of a commodity, based on the current prices, instead of speculating on future market changes. For example, the New York Stock Exchange is a spot market dealing with immediate purchases and delivery of stocks. Spot markets are sometimes referred to as the “cash market.”
As a general rule, spot prices are one of the factors considered when making futures contracts. But, because they are settled immediately, spot contracts do not need to take storage costs and interest into account, as is necessary with futures contracts.
What contango and backwardation mean for commodity prices
Commodity markets are often in a state of contango, meaning that the futures prices are higher than the commodity’s spot price. For example, if the spot price of oil in September is $50 per barrel, a market in contango would see futures prices higher in October, higher again in November, and with each successive period.
The opposite of contango is called backwardation. When a commodity market is in a state of backwardation, the futures prices are lower than the spot price of the commodity. This backwardation is often a sign that the prices are expected to fall moving forward. Another reason that a commodity can be in backwardation is if there is a shortage of the commodity in the spot market, leading to an increase in the current price.
Different factors can create contango or backwardation in the market. For example, for contracts with physical delivery, additional expenses such as storage costs or insurance can cause the futures prices to be higher than the spot price. Or, low warehouse stocks can lead to a higher convenience yield, causing backwardation in contracts with physical delivery.
Get access to the data you need to succeed in commodity trading
Any successful investor will agree that your prosperity is closely related to the quality of your market data. Most of the time, the biggest challenge isn’t simply having access to the necessary data – the problem is having the ability to sort through the data available so you can make informed trading decisions.
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