What are commodities and their types? Definition, types, example and how it works

Commodities are the essential raw materials that form the foundation of the global economy, effectively interchangeable goods that are grown, mined, or extracted rather than manufactured. These primary goods are commonly grouped into broad categories, such as hard commodities (e.g., oil and gold extracted from the earth) and soft commodities (i.e., agricultural products such as wheat and coffee), energy commodities, and metals. Their value responds to global supply and demand and are predominantly traded on financial exchanges not as physical products, but through futures contracts, that is, agreements to buy or sell a commodity in a specified amount and at a specified price on a specified date in the future—allowing everyone from small farmers to multinational corporations to hedge their positions (e.g., manage risk) and price speculate.

What are commodities?

Commodities, which are interchangeable with quantities of the same type in commerce, are finished goods or raw materials. These goods or raw materials are also fungible, which means that they are almost identical in quality and quantity, and they are usually standardized. Commodities are a basic building block of the global economy, often referred to as inputs for the production of commercial goods or services (or in many instances, simply traded directly within a marketplace).

Types of Commodities

Hard Commodities:

Hard commodities refer to natural resources that have been mined or extracted from the earth. Hard commodities can be physical goods in the form of metals, energy products, or minerals that cannot be cultivated or manufactured by human beings. Gold, silver, crude oil, natural gas, and copper are examples of a hard commodity. In the case of crude oil, it is a hard commodity that is extracted from the ground and turned into various fuels that we use daily, such as petrol and diesel.

Soft Commodities:

Soft commodities are agricultural goods that are cultivated rather than mined or extracted. They primarily include food and fiber products such as wheat, rice, coffee, cotton, and sugar. Coffee is an instance of a soft commodity. It is grown on farms and is then traded internationally as a staple beverage product.

How Commodities Work

Commodities serve as essential raw materials that are sold in bulk and transformed into goods and services. Due to the nature of commodities, they are typically standardized, indicating that one unit of a commodity is essentially indistinguishable from another. For instance, a barrel of oil or a kilo of wheat is interchangeable with another barrel of oil or kilo of wheat. Commodities are traded in both spot markets (where both buyers and sellers buy and sell goods for immediate delivery) and futures markets (where buyers and sellers agree today on a price for delivery at a later date).

Commodity prices are driven by supply and demand, and then compounded by global events, weather, geopolitical tensions, and economic growth. For example, if a drought occurs, prices for crops like corn or wheat, will likely increase in a negotiated or known marketplace due to lower supply. And after oil-producing nations cut production, the price of oil could increase internationally.

How Commodities are Traded in Stock Exchanges

The trading of commodities occur on a stock exchange, most commonly through a commodity exchange. Such exchanges include MCX (Multi Commodity Exchange) in India, CME (Chicago Mercantile Exchange) in the USA, and others. On these exchanges, the goods are not typically traded as physically taking possession of the goods, but instead are traded using derivative contracts like futures contracts or options contracts.

• How it works:
  • Futures contracts: An agreement to buy or sell a commodity (like gold, crude oil, or wheat) at a fixed price on a future date.
  • Options contracts: Give the right, but not the obligation, to buy or sell a commodity at a set price in the future.

Exchanging commodities on stock exchanges entails a standard system for price, quality, and time of delivery, making it simpler for buyers and sellers to participate. Farmers, producers, and companies utilize them to hedge against price fluctuations. Investors and traders employ them to profit from price fluctuations.

Examples of Commodity Trading

• Gold: Traded as a safe-haven asset. Investors buy gold futures or ETFs during economic uncertainty.
• Crude Oil: Traded on NYMEX, with prices affected by OPEC decisions or geopolitical events.
• Wheat: Traded on the CME, with prices fluctuating based on harvest yields or global demand.

Conclusion

In simple terms, commodities are essential goods such as oil, gold, wheat, or coffee that are traded on a global market due to their importance in the formation of global products and industries. They are typically categorized into either hard commodities (metals and energy) or soft commodities (crops and livestock). Commodities are traded on designated exchanges and often involve futures contracts, where two parties agree on a price on the exchange but the transaction happens later. Some people are simply looking to have the price change benefit them, while others like farmers or companies are using the transaction to manage the risk of price movements. Commodities are important to the economy, but their price movements could be impacted by anything from weather or global events. All in all, commodities are a mechanism to hedge or speculate involving supply, demand, and price movements linking producers, consumers, and traders.

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