How to Start Trading in Agriculture Commodity Markets

Anyone who wants to start trading in the agriculture commodity markets needs to understand the basics of futures trading. The bulk of trading in this market is done through futures contracts, rather than at spot prices or with the expectation of physical delivery. Once this basis of knowledge is established, you will be able to approach the details of the various agricultural markets and what factors drive prices.

Futures Contracts

A futures contract is a contract between two parties that binds the buyer of the contract to buy a set amount of a commodity at a set price at a set time. The seller of the contract is agreeing to make delivery of the agreed-to amount of the commodity in question at the specified time and to accept the agreed-upon price. While physical delivery is rare, it is the basis of the agricultural commodity futures market and should be understood. If you are asked to make or accept delivery, you may be in a very expensive position because at this point, the full amount rather than the leveraged derivative amount will be due. What this means is that futures trade on margin. It may cost you only $10,000 to control a $1-million-dollar position. At delivery, however, the full $1-million payment will be expected.

Market Participants

There are three main participants in the agricultural commodity markets. First, there are producers of the commodity. This includes primarily farmers and large agri-business. The next group you need to be aware of is the consumers of the commodity. This includes food manufacturers and often other farmers who may use one commodity in the course of their farming operation. Using wheat as an example, there are the wheat farmer and the bread company.

The other market participant is the speculator. This is the category you will join if you begin trading futures without first opening a farm or manufacturing company. Speculators provide price discovery and liquidity to the market by trying to profit from changes in the expected price of the commodity in question. While this will be your motivation, being aware that the other two parties exist is important because it drives the trends in prices–a drought pushes prices up because the farmer has less to sell to the bread maker. The bread maker needs the wheat, so the farmer can now demand a higher price.

Commodity-Specific Factors

The next thing you need to learn in order to begin trading is the details of the commodity in which you are interested. Staying with the wheat example, you need to know that one grade of wheat is traded in Chicago, while another is traded in Kansas City. While these are technically different products, they tend to trade in tandem, so one may be traded against the other as a hedge, rather than taking an outright position. Similarly, every commodity will be affected by weather patterns, demand factors and idiosyncratic risks specific to that commodity. If you want to be successful, it is important that you identify the risks for the given commodity and learn the details before placing a trade.