For Your Additional Questions(FAQ)

The economy can be divided into three sectors:

  1. Primary Sector: extraction of raw material from earth
  2. Secondary Sector: transformation of raw material into goods
  3. Tertiary Sector: supply of services to customers and business

Commodity market is mainly about the trading activities regarding the primary sector, namely, a market for those raw materials for the economy, and is also the foundation of economy.

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By goods

– Energy and Metal raw materials, including crude oil, natural gas, copper, and gold.
– Agricultural raw goods, including corn, soybean, coffee, sugar, and live cattle.

By form

– Physical goods
– Financial Derivatives: Futures, options, forwards, etc.

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Financial market is not a virtual world serving human being’s fantasy. So, yes, financial commodity derivatives are closely connected and highly related to the physical goods.

Financial market provides a variety of instruments for physical goods market player to hedge their market risk, and, to speculators, is a great playground to execute speculation.

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It is a big question.

Hedging attempts to lower market price risk by taking offsetting position.

Speculation is to bet on the market price movement, sometimes might sound like gambling.

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Position is where you are.

Three basic types: long position, short position, and square position.

If you bought 10 iPhones and want to sell it, then you are in Long Position. You make profit if iPhone price goes up.  So, people want to hold a long position with expectation that market will rise.

If you promised someone to sell him 10 iPods at certain price but you haven’t buy any yet, then you are in Short Position and hoping the market goes down.

If you bought 10 MacBook and sold 10 MacBook, then you are in Square Position.

  • So how to hedge by taking offsetting position?

The offsetting position of long position is short position, and the one of short position is long position.

  1. The most straightforward offset is to sell what you bought, or to buy what you sold to fix the margin.If you are holding 10 apples (10 apple long position), then the simple offsetting position is to short/sell the 10 apples to another guy, then fix the margin.
  2. If two goods are highly related in terms of price, then this two goods could be hedged on each other.For example, Gasoline and Crude Oil.

    An Oil Refiner, Joe, knows the cost of refining in his company is 10$, and market shows Gasoline Price is 30$ higher than Crude Oil per unit, so Joe could make 20$/unit. Joe has bought 100 units of Crude Oil, and is worried about this oil refining margin would go down. So his team sold 80 units of Gasoline’s forward contract, and 10 units of Gasoline’s Future Contract, and 10 units of Gasoline Put Option.

    So, Joe was in 100 Long Position, and hedged in highly related goods to fix his profit by shorting all kinds of financial instruments. (will explain those instruments later.)

  • Who are the hedgers and who are the speculators in the financial commodity market?

In trading, one activity is either hedging or speculation, and a player could be a hedger at this moment then changes into a speculator in next minutes. One trade might seem like a speculation in this market but in fact is a hedging trade linked another market. Basically, it is very hard to identify whether it is hedging or speculation,  as it depends on the purpose of those actions and the mind is hard to prove.

However, in general, most of physical commodity related parties are hedgers, and the rest are the speculators, including those hedge funds, and some rich gamblers.

Theoretically, this market provides this function:

Hedgers could pass the market volatility risk to the speculators by giving up potential market gain, while speculators gain the potential market gain by taking that risk.

It might sounds like a zero-sum game on money, but actually, make the both parties better off in terms of needs/utilities.

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