Commodities Futures and How They Work,

Why Do Prices of the Things You Need the Most Change Every Day?

men grocery shopping
The price you pay for groceries is determined by commodities futures. Photo: Doug Menuez/Getty Images

Definition: Commodities futures are agreements to buy or sell a raw material at a specific date in the future at a particular price. Just like the price of bananas at the grocery store, the prices of commodities change on a weekly or even daily basis. That's because bananas are commodities. So are most other food items, such as meat, wheat, and sugar. Commodities futures are also traded in energy products, like oil and gasoline, and metals, such as gold, silver, and copper.

How They Work

If the price goes up, the buyer of the futures contract makes money. He gets the product at the lower, agreed-upon price and can now sell it at the today's higher market price. If the price goes down, the futures seller makes money. He can buy the commodity at today's lower market price, and sell it to the futures buyer at the higher, agreed-upon price.

Of course, if commodities traders had to deliver the product, few people would do it. Instead, they can fulfill the contract by delivering proof that the product is in the warehouse. They can also pay the cash difference, or by provide another contract at the market price.

How They Affect Prices

Commodities futures accurately assess the price of raw materials because they trade on an open market. They also forecast the value of the commodity into the future. The values are set by traders and their analysts, who spend all day every day researching their particular commodity.

Forecasts instantly incorporate each day's news. For example, if North Korea tests a nuclear weapon, the commodities prices will change dramatically.

Most of the time, prices are an accurate reflection of market conditions. But like any other traded item like stocks or bonds, commodities futures can reflect the emotion of the trader or the market as much as underlying fundamentals.

Often speculators will bid up prices to make a profit, especially if a crisis occurs and they anticipate a shortage. When other traders see that the price of a commodity is skyrocketing, they can create a bidding war and drive the price even higher. The basics, like supply and demand, haven't changed. Then, when the crisis is over, the prices can plummet.

That happens most often to two popularly-traded commodities, oil, and gold. In January 2013, oil futures prices started rising when Iran started playing war games near the Straits of Hormuz. Traders were worried that a potential closure of the Straits would limit oil supplies. For more, see What Makes Oil Prices So High?

In 2011, gold hit an all-time high of $1,895. Demand and supply hadn't changed, but traders bid up gold prices in response to fears of ongoing economic uncertainty. Gold is often bought in times of trouble because many people see it as a safe haven. For more, see Gold Prices and the U.S. Economy.

How to Invest in Commodities Futures

The best way to either invest in or monitor commodities futures is through a commodities ETF or commodities mutual fund. These can give you a single number that takes into account the broad spectrum of commodities futures that are occurring at any given time, such as the GSCI.

That's because trading in commodity futures and options contracts is very complicated and risky. Commodities prices are very volatile, and the market is rife with fraudulent activities. If you aren't completely sure of what you are doing, you can lose more than your initial investment. If you want to invest in commodities, please see Commodities Profiles and Day Trading in Commodities Futures. Also, review the CTFC's Guide to Fraudulent Activity and its Education Center.

Commodities FAQ