The term "commodity futures" refers to an agreement to buy or sell a commodity at a specified price on a future date. Commodity futures are exchange-traded, meaning that they are bought and sold on the open market in the same way that stocks and bonds are. Like stocks and bonds, commodity futures are also subject to "marking to market," in which the value of the agreement is determined daily, based upon the current price of the commodity.

However, commodity futures have additional costs and risks associated with them that stocks and bonds do not have. Because commodities are tangible assets, non-agricultural commodity futures have additional cost components associated with holding them. Costs associated with commodity futures are often referred to as carrying costs and include storage costs, insurance costs, and costs related to any commodity damage that occurs during storage.

Note that for analysis sake, the carrying costs associated with commodity futures are typically assumed to be paid at the time of contract maturity. These carrying costs, along with any interest costs, must be considered to determine the real cost of the commodity future.

Now that we understand the basics of commodity futures, let's take a deeper look at by considering what can be referred to as the ABC's of commodities.

A is for arbitrage: Arbitrage refers to an investment which has no risk and no net gain for either party. Obviously, the arbitrage pricing theory is merely a theoretical way to examine commodity futures since all investments require some risk. Those who study arbitrage pricing theory (or arbitrageurs) help to keep commodity futures prices in line with the underlying financial asset through determining any discrepancies and investing accordingly.

B is for beta: Since we know from arbitrage theory that all investments carry some risk, beta refers to the risk of investment related to commodity futures. B also stands for basis, which is the difference between the futures price and the spot (current) price. Both beta and basis are important considerations in commodity future analysis.

C is for commodity types: For the purpose of our discussion, we will break commodities into two basic types agricultural and non-agricultural commodities. The reason for breaking down commodity futures in this way is that the cost of purchasing perishable agricultural commodities is analyzed differently than commodities such as gold and oil. Carrying costs for agricultural commodities may be negligible as many agricultural commodities are typically not stored for any period of time (i.e. think about corn, wheat, and other farm products you don't want to keep it around too long or it will spoil!).

Also note that, unlike gold and oil, agricultural commodities will follow a seasonal price fluctuation. Specifically, agricultural commodity prices will rise steadily before the harvest and drop dramatically once the harvest is completed and the new crop is sold.

So, why would someone want to buy a commodity future? Agricultural commodity futures appeal to farmers and others whose livelihood is dependent upon their crops. In this case, commodity futures work as a hedge for the farmer, acting as an insurance policy in case crop prices fluctuate greatly or his crop is inadequate.

Non-agricultural commodity futures work in the same way they enable companies to lessen their risk and diversify their portfolios in cases where their livelihood is dependent upon a certain commodity. For example, oil and gas futures help airlines and other transportation companies to hedge their risk against rising fuel prices.

Commodity futures can serve as an effective way to lock in a commodity purchase at a future date. Before purchasing commodity futures, one must examine the risks and costs associated with this somewhat volatile investment mechanism.