What are commodity derivatives? A commodity derivative is an investment tool used by expert traders as well as ordinary men of business in order to make a profit even without having ownership or possession of goods.

Admittedly a commodity derivative is something not easily understood. This article endeavors to provide some basic information as well as examples of commodity derivatives in order to completely and concisely answer the question “What are commodity derivatives?”

What Are Commodity Derivatives: A Definition

The term commodity derivative is made up of two words. The first is “commodity” which is any goods or service used in trade. The second word is “derivative” which means future product or result. Simply put commodity derivatives are future products or spin off’s of goods and services which allow a person to create a profit without actually having possession or ownership of the same, but will eventually do in the normal course of business.

What Are Commodity Derivatives:Chicago Board of Trade

In 1848 the Chicago Board of Trade devised a way to create revenues for farmers who needed money to buy seeds, fertilizers as well as farm implements and tools without having any produce on hand. They allowed the farmers to sell the rights to future crops. Not only that but the price of the goods were prearranged in order to protect the farmer from the fluctuating market and create a bit of stability in the price of produce.

What Are Commodity Derivatives: For Example

For example, If Farmer A needed money to finance the planting of corn he only had to arrange for the selling of the commodity derivative at a prearranged price and then buy the seed, fertilizer and tools on credit from stores who know of the arrangement. This means no money actually changes hands but the farmer gets what he needs, a trader profits from the trade, a merchant sells on credit and another merchant is assured of a steady supply of corn at a pre arranged price.

What Are Commodity Derivatives: A Contemporary Approach

Nowadays it is not the simple farmer or the commodity owner or possessor that profits form from commodity derivatives. Rather it is the middleman, broker or the speculator who does so.

What Are Commodity Derivatives: A Modern Day Example

For example, a broker looks at the market price of a certain commodity today and then studies how the same price has risen or fallen over a specified period of time. These charts determine both the demand and the supply of the goods in question. The broker then buys the commodity derivative that looks to be selling low but will probably command a higher price in the future.

What Are Commodity Derivatives: The Trade

The broker makes an educated guess as to what price the commodity will be in a given future time then buys up the particular commodity. The goal of the broker is to buy when prices are low expecting the price to increase and then sell at the point when the price is at its highest in order to maximize profits. You can just imagine how risky this type of trading is and the price of the commodity derivative can just as easily go own, meaning a loss for the broker.

What Are Commodity Derivatives: The Margin Price

This is the minimum price a broker pays in order to get the right to buy the commodity at a given future time for a particular given price.  Of course full payment still occurs but they are becoming less and less frequent and are common only in highly prized goods with very  high demand but low supply. The margin price usually forms part of the selling price.

What Are Commodity Derivatives: Contract Seller

Is another middle man who works for the owner of the commodity to ensure that the margin price as well as total price for the commodity is at its maximum. Usually these brokers get paid via a percentage that is why the desire to get the best price is always presumed.