The commodities market has two basic types of trades – physical commodities and non-physical financial contracts. Physical commodities that underly a futures contract or are traded in the physical market are known as actuals. Since non-physical financial contracts, such as swaps, can involve extra liquidity risk, traders should know the difference between the two different types of assets before trading them. The concept has even become important for many ETFs that hold actuals versus financial contracts, as non-physical funds could involve significantly more risk than those that hold actuals.

Backwardation occurs when near month futures are more expensive than those expiring further into the future, creating a downward sloping curve for future prices over time. This can happen when the cost of carry (costs associated with holding the position) or convenience yield (benefit to owning the asset) exceed the risk-free rate otherwise offered in the market.

Contango is the opposite of backwardation and occurs when near month future contracts are cheaper than those expiring further into the future, creating an upward sloping curve for future prices over time. For non-perishable commodities that have a cost of carry, contango is normal, as the commodity holder must pay for these costs above and beyond the cost of the commodity itself. However, contango can also occur when a commodity falls out of favor and there’s a negative convenience yield associated with holding it over time, just as a positive convenience yield positively affects backwardation [see Understanding Contango: Natural Gas Example].

Stock certificates may be virtually free to hold for investors, but most commodities involve some kind of cost associated with holding them. For instance, someone has to pay to store physical gold before its delivery. These costs are known as carrying costs and they are usually negative for commodities, unless the futures market is willing to pay a sufficiently high premium for future delivery, as with gold during many financial crises. Commodities with a negative carrying cost are referred to as negative carry, while those with a positive carrying cost (e.g. return from holding it) are referred to as positive carry commodities.

The commodity markets consist of three different types of traders: Commercial hedgers, non-commercial traders and non-reporting retail speculators. Commercial hedgers, or commercials, represent the largest of the three types of traders, using commodities as a tool to hedge their businesses rather than speculate on future direction. For instance, a wheat producer may short wheat futures contracts to protect his or her profits, if prices fall in the near-term. The positions held by these traders can be seen in the Commitment of Traders report put out by the CFTC and are important to consider given their effects on market prices [see The Ten Commandments of Commodity Investing].

Margin is a necessary component of futures trading, as it wouldn’t be very cost effective to purchase entire contracts in cash. Initial margin refers to the amount of money that must be put up to buy or sell a futures contract as a percentage. Additional margin that may be required throughout the duration of the trade is known as a maintenance margin. These margin rates are set by futures exchanges using a special algorithm, but some brokerages will add an extra premium to lower their own risk exposure. Knowing and tracking these margins is important in order to stay cognizant of both a trade’s cost basis and risk exposure.

Commodities are unlike equities in that they carry an expiration date, where the futures contract’s price converges to the commodities spot price over time. One way to measure the returns from these movements is by using the roll yield, which is the yield that traders capture when the futures contract’s price makes this move over the remaining duration of the contract. In backwardated futures, the roll yield is positive as the futures contract rolls up to the spot price, while the roll yield is negative in contango where the futures contract rolls down.

The commodities market involves a lot of terminology that may be unfamiliar to those that have only traded equities in the past. It’s very important for new traders to understand these terms in order to avoid costly mistakes, as well as understand market commentary and analysis, which use the terms liberally.

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Disclosure: No positions at time of writing.