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How commodities trade: Key terms, quiz and sources

Understanding Commodities / Module 6: How commodities trade Wrap-up

How commodities trade: review

Key terms

Spot transaction
A sale for immediate delivery, or after only the minimum lag needed to load and ship.
Forward contract
A bilateral agreement to deliver a set quantity at a fixed or formula price on a future date, with terms tailored by the two parties.
Futures contract
A standardised forward traded on an exchange, cleared centrally and settled daily through margins.
Clearing house
The body that becomes counterparty to every trade on an exchange, so that traders bear only its credit risk.
Initial and variation margin
The deposit required to open a futures position and the daily payments that settle gains and losses.
Exchange for physical
A deal in which holders of opposite futures positions close them and agree a physical delivery between themselves.
Warrant
A document of title to exchange-approved metal in a licensed warehouse, allocated to buyers who take delivery.
Contango and backwardation
Futures above spot, capped by the cost of storage and interest; and spot above futures, limited only by the convenience of holding stock.
Convenience yield
The benefit of having stock on hand, which explains why inventories are held even when futures trade below spot.
Short and long hedge
Selling futures against goods held or to be produced, and buying futures against goods that must be bought later.
Basis
The spot price minus the relevant futures price, reflecting grade, location and timing differences.
Basis risk
The risk that the basis changes during a hedge, leaving part of the exposure unprotected.
Option premium
The price paid for an option, made up of intrinsic value and time value.
Squeeze or corner
Control of deliverable supply, often with a large long position, that forces shorts to buy back at inflated prices.
Price reporting agency
A publisher such as Platts, Argus or Fastmarkets that assesses prices from surveyed deals where no exchange price exists.
Physical arbitrage
Buying a commodity in one place, time or form and selling it in another when the price gap exceeds the cost of transformation.
Offtake agreement
A contract to buy a set share of a producer's output, usually at a floating price, often used to help finance the project.
Prepayment
An advance to a producer repaid through future deliveries, with the interest built into a discount on the price.

Try it in the table

  • Open Copper. Note the three exchanges that quote it and the gap between the September 2025 and September 2026 prices. Rework the copper fabricator's hedge for an order of 500 tonnes, and list the costs the futures do not cover.
  • Open Nickel and look at the price chart around March 2022 and the production shares. Explain, using the share of Indonesian output and the Class 1 contract, why a squeeze happened while the market was in surplus.
  • Open Iron ore and Crude oil. For each, identify the benchmark, who publishes or trades it, and how a non-benchmark cargo is priced as a differential to it.
  • Open Wheat and Maize. Using the trading lenses and the October 2026 WASDE figures, describe a short hedge for a US farmer and a long hedge for a miller or feed mill, and name one source of basis risk for each.
  • Open Uranium, Lithium and Cobalt. Each lacks a deep futures market. Using the five conditions for a successful futures contract, decide which condition each fails, and note who assesses its price instead.
  • Open Zinc and Aluminum. Read the 1991-92 zinc corner in the zinc trading lens, and recall the 1988 aluminium squeeze from this module. For each, explain what LME warehouse stocks and the cash to three-month spread would have shown while the squeeze was under way.

Final quiz

About what share of futures contracts end in physical delivery, according to Geman?

Most positions are closed by an offsetting trade. The possibility of delivery still forces futures and spot prices to converge at expiry.

Why does arbitrage cap a contango but not a backwardation?

Cash-and-carry arbitrage limits contango to the cost of storage and interest. In backwardation only the convenience yield of stocks restrains the gap.

Pirrong describes the main effect of hedging on a trading firm's risk as:

A hedge with a standardised contract removes most exposure to the price level but leaves the risk that the hedged good and the hedge diverge.

Which event led NYMEX to diversify into petroleum futures?

After the potato default nearly ruined it, the exchange launched heating oil, gasoline and, in March 1983, WTI crude futures.

What replaced annual benchmark negotiations for seaborne iron ore around 2010?

Humphreys describes quarterly and then shorter pricing on Platts, Metal Bulletin and The Steel Index assessments for 62% iron ore delivered to China.

In the 1988 aluminium squeeze, what sign showed shorts were trapped?

With Weiss's position larger than LME stocks, shorts had to buy back at any price, producing an extreme backwardation of $4,290 cash against roughly $1,000 less for three months.

What made the Sumitomo copper affair different from the Hunt silver affair?

Hamanaka's unauthorised trades cost Sumitomo more than $2 billion. The Hunts were principals deliberately building positions and taking delivery.

In the Jamaican alumina deal, what did Marc Rich + Co give and get?

Blas and Farchy describe a ten-year offtake with cash advances and input supply, at terms the World Bank later judged about 25% below typical contracts.
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Sources for this module