What Are Commodities?
Raw materials trade in a number of ways. First there’s the physical commodity market. A barrel of oil, a bar of gold, a truckload of corn or soybeans, a bag of coffee, or even a herd of cattle are examples of the physical staples at the heart of commodity markets. Everything else that trades is a derivative. This is an instrument with a price that reflects the value of the underlying hard commodity asset. Physical commodity trading occurs among producers, traders, and the end consumers. In the derivative markets, it’s the speculators, investors, arbitrageurs, and other interested parties who make the assets liquid.
What Is Liquidity in Commodities?
Different commodity raw materials offer different degrees of liquidity. Let’s look at some of the more liquid and less liquid commodity sectors and specific markets to understand the concept of liquidity.
Precious metals: The most liquid precious metal is gold, because it has more trading activity than any other precious metal. Gold trades in the physical market as well as in the OTC forward and swap markets. There are liquid gold futures and options contracts on exchanges as well as ETF and ETN products based on the metal. Other precious metals are less liquid. For instance, there’s rhodium, another precious metal. Rhodium only trades in the physical market. That makes gold far more liquid than rhodium because there are no rhodium futures to trade. Energy: Crude oil may be the most liquidly traded and prevalent commodity in the world. Coal, meanwhile, does not trade to the same extent or with as many derivatives as crude oil does. Therefore, crude oil is a more liquid energy commodity than coal.
Those are just two cases of commodities within the same sector having different degrees of liquidity. All of the major sectors have them—including other metals, energies, grains, soft commodities, and animal proteins or meats.
How Can You Tell Whether a Commodity Market Is Liquid?
Certain conditions make a market liquid. Look for these characteristics, which tend to be the case in all liquid commodity markets:
An active spot or cash underlying market in the physical commodityMany buyers and sellers—hedgers, speculators, investors, and othersAn open, transparent, and non-discriminatory delivery methodA well-defined relationship between the derivative and the physical commodityA way to exchange the cash commodity and derivativeA convergence of the cash price and prices that reflect future delivery over time
Futures markets are more liquid because they meet all these characteristics. You can measure the liquidity of specific futures products by looking at daily trading volumes and open interest, and the number of open (but not closed) long and short positions. The higher the volume and open interest, the more liquid a market is.
Why Is Liquidity Important?
Liquidity is important for all assets, not just commodities. Liquidity ensures traders can buy and sell easily. That brings speculators and investors into a market. An illiquid market tends to be far more volatile than a liquid one because fewer trades can make pricing less stable. Indeed, the most important feature of liquidity is that it lowers the cost to trade or invest. When investing in commodities—or any asset class—make sure you choose liquid instruments so that you can buy and sell without problems at the lowest trading cost. The bid/offer spread on an asset represents the cost to buy and sell. The most liquid assets have the tightest bid/offer spreads. Less liquid markets tend to have a wider spread between buying and selling prices, thus raising trading costs.
