Commodities differ from many other forms of investment in that they are physical substances that need to be produced in order to be purchased or sold on an exchange. For example, grains or food products cultivated by farmers are stored in the hope that they will sell at a good price at a future date.
The spread between a commodity and a product (i.e. a commodity-product spread) involves the purchase of a particular commodity and the resulting sale of the product generated from commodities of the same type. Generally speaking, these two transactions take place at the same time; however, in the event that there is a small period of time between the executions of the transactions, this is still regarded as a commodity-product spread.
Products can also be sold in reverse order, resulting in the sale of products before the products made with the same type of commodity are purchased. In this case there is usually a period of no longer than 30 days between the two transactions that result in the spread.
Under the wide classification of a commodity-product spread there are a number of specific spreads. One example is a crack spread, which is essentially a commodity-product spread involving a particular type of commodity such as crude oil. For example, a crack spread is the purchase of crude oil together with the sale of products such as gasoline or heating oil.
A crush spread, which is another example of a commodity-product spread, usually involves food products such as soybeans or corn. With a crush spread an investor may decide to purchase soybean futures and sell a future associated with soybeans, such as meat substitutes made with soybeans, soy milk or soybean oil.
The intention of a commodity-product spread is to enable an investor to trade on a commodity market that is currently in the midst of an upswing. The purchased commodity will usually be obtained at a good price, while the commodity sold will earn a good return on investment that covers the cost of the commodity futures contract. Usually, trading on a commodity-product spread carries reduced risk when compared with other investments.
Contract grades are standards that are related to different types of commodity investments. Placing a contract grade on a commodity helps to establish the detailed status of a futures contract and ensures that it is deliverable as set out in the terms specified in the contract. Contract grades also ensure that investors get what they pay for when trading commodities.
Establishing a contract grade or standard usually involves the government of the jurisdiction where the commodity exchange is located. This government will provide a broad set of rules and regulations pertaining to any commodity traded on the market. Furthermore, the actual market or exchange involved in the trade can establish a contract grade. In both cases the intention of the regulations and laws is to establish reasonable contract grades that appropriately represent the underlying value of the commodity to potential investors, and to ensure that all transactions are conducted in an honest and sincere manner.
In some markets contract grades are described as deliverable grades. This highlights the fact that the standards established for the commodities must appropriately meet the terms of the contract. In the event that they do not meet the terms of the contract, there is usually a mechanism that is employed to reverse the transaction.
Although contract grades are usually consistent there are occasionally times when they are subject to change. For example, in the event that there is a change in the availability of a commodity this could impact contract grades. Likewise if there are changes to environmental or political circumstances, this could stimulate or hinder the creation of a commodity. Nevertheless, both the government regulations and the commodity exchange rules aim to amend contract grades in a manner that allows an investor to remain aware of the current status of a given commodity, clarifying whether or not investing in that commodity is a viable option.
A commodity exchange is a specific trading organization that engages in transactions involving the purchase and sale of options and futures associated with the commodities market. Although a commodity exchange usually maintains a physical location where trading occurs, it may also provide access to trading activity through the internet.
Some of the most well-known commodity exchanges in the world include the COMEX (formerly known as the Commodity Exchange Inc.), London Commodity Exchange and Tokyo Commodity Exchange.
A commodity exchange must create and maintain a platform of processes, rules and standards that will govern all trading activity of the exchange. All procedures and regulations must be followed in strict compliance with national laws pertaining to investment trading within the regions where commodity exchanges are physically located.
All commodity exchanges are free to engage in all commodity-related trading and futures activity. Some exchanges may specialize more in food products while others might focus on precious metals or grain products.
Participating with a commodity exchange can be done individually or as part of a commodity pool. For investors who trade on an individual basis, it is essential to meet with the margin requirements as established by the exchange. On the other hand, investors who participate in a commodity pool are part of a group of investors who pool their resources together for trading purposes. In some cases, brokers may also be appointed to execute orders for individual investors or pool of investors.