DEFINITION of Soft Commodity
Soft commodity refers to futures contracts where the actuals are grown rather than extracted or mined. Soft commodities represent some of the oldest types of futures know to have been actively traded. This storied group includes cotton, sugar, rice and wheat as well as all manner of livestock. Soft commodities are sometimes referred to as tropical commodities or food and fiber commodities.
BREAKING DOWN Soft Commodity
Soft commodities play a major part in the futures market. They are used both by farmers wishing to lock-in the future prices of their crops, and by speculative investors seeking a profit. Due to the uncertainties of weather, pathogens and other risks that come with farming, soft commodity futures tend to be more volatile than other futures. For example, weather and seeding/harvesting reports can cause the prices of the grains and oilseeds to fluctuate significantly, impacting the values of contracts differently depending on the delivery dates.
Soft Commodities Versus Hard Commodities
Soft commodities are less well defined than hard commodities. Soft commodities are best understood as grown commodities. Coffee, cocoa, orange juice, sugar, canola, corn, lumber, wheat, lean hogs, feeder cattle and so on all go through a growth cycle which ends in harvesting - usually for further processing. This is in contrast to the hard commodities that include mined metals (copper, gold, silver, etc.) and energy extraction (crude oil, natural gas and products refined from them). Hard commodities are waiting in the earth for extraction, as opposed to being planted and nurtured to maturity. Hard commodities can also be found in similar geological deposits around the world, whereas soft commodities depend on regional climate conditions to grow.
Alternative Classifications of Soft Commodities
As there is no definitive list of what is and is not a soft commodity, alternative classifications have cropped up. Agricultural commodities is sometimes used to refer to meat, livestock, cereals, grains and oilseeds, leaving cocoa, orange juice and so on in the category of soft commodity. This isn’t a great solution as lumber is shoehorned into one or the other, creating and agriculture and forestry category or a softs, food and fiber grouping. CME group, for example, only lists coffee, sugar and cotton futures as soft commodities within the broader category of agricultural futures, whereas ICE lists cocoa, coffee, sugar, cotton and orange juice with additional grains and agricultural products underneath the soft commodity category.
Of course, whether a contract is classified as a soft commodity or not is less important to a futures trader than the understanding of the underlying commodity and its historical trends. Because of their volatile nature and differing supply and demand cycles, soft commodities can be more challenging to trade than hard commodities. As with any derivatives trade, investors should understand the market they are entering as well as the implications of the contract they are using to enter well in advance of putting real money on the line.