What is a 'Commodity'
A commodity is a basic good used in commerce that is interchangeable with other commodities of the same type. Commodities are most often used as inputs in the production of other goods or services. The quality of a given commodity may differ slightly, but it is essentially uniform across producers.
When commodities are traded on an exchange, they must meet specified minimum standards, also known as a basis grade.
The sale and purchase of commodities is usually carried out through futures contracts on exchanges that standardize the quantity and minimum quality of the commodity being traded. For instance, the Chicago Board of Trade stipulates that one wheat contract is for 5,000 bushels and also states what grades of wheat can be used to satisfy the contract.
There are two types of traders that trade commodity futures.
- Buyers and producers of commodities that use commodity futures contracts for the hedging purposes for which they were originally intended. Theses traders actually make or take delivery of the actual commodity when the futures contract expires. For instance, 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 trader or speculator. These are traders who trade in the commodities markets for the sole purpose of profiting from the volatile price movements. Theses 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 intra-day 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 also be used effectively to diversify an investment portfolio.