Emily RobertsCommodities are an important aspect of everyday life for most people. A commodity is a basic good used in trade that is interchangeable with other goods of the same type. Traditional examples of commodities are grain, gold, beef, oil, and natural gas.
For investors, commodities can be an important way to diversify their portfolios beyond traditional stocks. Because commodity prices tend to move in opposition to stock prices, some investors also rely on commodities in periods of market volatility.
In the past, commodities trading required large amounts of time, money and expertise, and was limited mainly to professional traders. Today there are more options for participating in the commodities markets.
In a Nutshell
- Commodities are basic products that are used in trade and can be exchanged for other goods of the same kind.
- Commodities can play a significant role in portfolio diversification beyond standard stocks.
- Compared to equities and bonds, commodity trading has a longer history.
- The four major types of commodities are: metals, energy, livestock and meat, and agriculture.
- Futures contracts, equities, ETFs, notes, mutual funds, index funds, commodity pools, and managed futures are all ways that investors can access the commodities market.
- In the most basic sense, commodities are known to be risky investment propositions because their market (supply and demand) is affected by uncertainties that are difficult or impossible to predict, such as unusual weather patterns, epidemics and both natural and man made catastrophes.
History of Commodities Trade
Trading commodities is an old job that has been around longer than trading stocks and bonds. Many empires grew because they were able to set up complicated trading systems and make it easy for people to trade goods.
Today, commodities continue to be traded around the world. A commodity exchange refers both to a physical location where commodity trading takes place and to legal entities that have been formed for the purpose of enforcing rules for the trading of standardized commodity contracts and related investment products.
βHe who controls the spice controls the universe.β
Frank Herbert
Some commodity exchanges have merged or gone bankrupt in recent years. Most exchanges trade several commodities, although some specialize in a single commodity group. In the United States there is the Chicago Mercantile Exchange (CME), the New York Mercantile Exchange (NYMEX) and the Intercontinental Exchange (ICE) in Atlanta, Georgia. In Europe there is the London Metal Exchange (LME). As its name suggests, the London Metal Exchange only trades metals.
Special Features of the Commodities Market
In the broadest sense, the basic principles of supply and demand drive commodity markets. Changes in supply have an impact on demand; tight supply equals higher prices. So, a big change in the supply of a good, like a disease that affects a lot of livestock, can cause a big change in the demand for that good. In the case of livestock, this can be caused by a widespread health problem.
Global economic development and technological advances can also influence prices. For example, the emergence of China and India as major manufacturing players (thus demanding a greater volume of industrial metals) has contributed to reducing the availability of metals, such as steel, to the rest of the world.
Types of Raw Materials
Commodities traded generally fall into four broad categories: metals, energy, livestock and meat, and agriculture.
Metals
Metallic commodities include gold, silver, platinum, and copper. During times of market volatility or bear markets, some investors may decide to invest in precious metals, especially gold, because it is a reliable and safe metal with real and transferable value. Investors may also decide to buy precious metals as a way to protect themselves from times of high inflation or when the value of the currency goes down.
Energy products include crude oil, heating oil, natural gas and gasoline. Developments in the global economy and declining production from established oil wells around the world have historically led to higher oil prices, as demand for energy related products has increased at the same time that oil reserves have declined.
Alex GoodmanEnergy
Investors interested in entering the energy commodities market should also be aware of how economic recessions, changes in production imposed by the Organization of the Petroleum Exporting Countries (OPEC) and new technological advances in alternative energy sources (wind energy, solar energy, biofuels, etc.) that aim to replace crude oil as a primary energy source can have a huge impact on the market prices of energy commodities.
Livestock and meat raw materials include lean hogs, pork bellies, live cattle and fattening cattle.
Agriculture
Agricultural commodities include corn, soybeans, wheat, rice, cocoa, coffee, cotton and sugar. In the agricultural sector, grains can be very volatile during the summer months or during any period of weather transition. For investors interested in the agricultural sector, population growth combined with limited agricultural supply can offer opportunities to benefit from rising agricultural commodity prices.
Using Futures to Invest in Commodities
One way to invest in commodities is through a futures contract. A futures contract is a legal agreement to buy or sell a certain commodity at a certain price at a certain time in the future. When a futures contract runs out, the person who bought it has to buy and take delivery of the underlying commodity.
The seller of the futures contract assumes the obligation to provide and deliver the underlying commodity on the maturity date of the contract. Futures contracts exist for all categories of commodities. Typically, there are two types of investors who participate in commodity futures markets: commercial or institutional users of commodities and speculative investors.
Manufacturers and service providers use futures contracts as part of their budgeting process to normalize expenses and reduce cash flow headaches. Manufacturers and service providers that rely on raw materials for their production process may take positions in the commodities markets as a way to reduce their risk of financial loss due to a change in price.
The airline industry is an example of a large industry that must secure massive amounts of fuel at stable prices for planning purposes. Because of this need, airlines resort to hedging with futures contracts. Futures contracts allow airlines to purchase fuel at fixed prices for a set period of time. In this way, they can avoid any volatility in the crude oil and gasoline market.
Agricultural cooperatives also use futures contracts. Without the ability to hedge with futures contracts, any volatility in the commodity market has the potential to bankrupt businesses that require a relative level of predictability in commodity prices to manage their operating expenses.
Speculative investors also participate in the commodity futures markets. Speculators are sophisticated investors or traders who buy assets for short periods of time and employ certain strategies to profit from changes in the price of the asset. Speculative investors expect to profit from changes in the price of the futures contract.
Because they do not depend on the actual assets they speculate on to maintain their trading operations (like an airline company actually depends on fuel), speculators often close out their positions before the futures contract expires. As a result, they may never receive the actual commodity itself.
If you do not have a broker who also trades futures contracts, you may be required to open a new brokerage account. Investors are also usually required to fill out a form acknowledging that they understand the risks associated with futures trading. Futures contracts will require a different minimum deposit depending on the broker, and the value of your account will increase or decrease with the value of the contract.
If the contract value decreases, you may be required to deposit more money into your account to keep the position open. Due to the high level of leverage, small swings in commodity prices can result in large profits or large losses; a futures account can disappear or double in a matter of minutes.
Futures contracts offer many advantages as a method of participating in the commodities market. Analysis can be simpler because it is a pure play on the underlying commodity. There is also the potential for large profits and, if you can open an account with a minimum deposit, you can control full size contracts (which would otherwise be difficult to afford). Finally, it is easy to take long or short positions in futures contracts.
Livestock and Meat
Because markets can be very volatile, investing directly in commodity futures contracts can be very risky, especially for inexperienced investors. The downside to the huge profit potential is that losses also have the potential to be magnified; if a trade goes against you, you could lose your initial deposit (and more) before you have time to close your position.
Most futures contracts offer the ability to purchase options. Futures options can be a less risky way to enter the futures markets. One way to think of buying options is similar to depositing an amount rather than buying it outright. With an option, you have the right but not the obligation to carry out the trade when the contract expires. Therefore, if the price of the futures contract does not move in the expected direction, the loss is limited to the cost of the option purchased.
Using Stocks to Invest in Commodities
Many investors interested in entering the market for a particular commodity will invest in shares of companies related in some way to that commodity. For example, investors interested in the oil sector may invest in oil drilling companies, refineries, oil companies, or diversified oil companies. For those interested in the gold sector, some options are to buy shares in mining companies, smelters, refineries, or any company that trades bullion.
Stocks are generally considered to be less prone to price swings than futures contracts. Stocks can be easier to buy, hold, trade and track. In addition, it is possible to limit investments to a particular sector. Of course, investors should do some research to make sure that a particular company is a good investment and a good business.
Investors may also purchase stock options. Like options on futures contracts, stock options require a smaller investment than the outright purchase of stock. Thus, although your risk in investing in a stock option may be limited to the cost of the option, the price movement of a commodity may not directly reflect the stock price movement of a company with a related investment.
One advantage of investing in stocks to enter the commodities market is that trading is easier because most investors already have a brokerage account. Investors can easily access public information about a company’s financial condition, and stocks are usually very liquid.
Investing in equities as a way of accessing the commodities market has some relative disadvantages. Stocks are never a pure play on commodity prices. In addition, the price of a stock can be influenced by factors related to the company that have nothing to do with the value of the commodity the investor is trying to track.
Use of ETFs and Notes to Invest in Commodities
Exchange traded funds (ETFs) and exchange traded notes (ETNs) give investors who want to get into the commodities market more ways to do so. ETFs and ETNs trade like stocks and give investors the chance to profit from price changes in commodities without having to buy futures contracts directly.
Commodity ETFs typically track the price of a particular commodity or a group of commodities that make up an index through futures contracts. Sometimes investors back the ETF with the commodity itself in storage. ETNs are unsecured debt securities designed to mimic the price fluctuation of a particular commodity or commodity index. ETNs are backed by the issuer.
ETFs and ETNs allow investors to participate in the price fluctuation of a commodity or basket of commodities, but typically do not require a special brokerage account. In addition, ETFs and ETNs do not charge management or redemption fees because they trade like stocks. However, not all commodities have ETFs or ETNs associated with them.
Another drawback for investors is that a significant change in the commodity price may not be reflected on a point by point basis in the underlying ETF or ETN. In addition, ETNs have a specific credit risk associated with them, as they are backed by the issuer.
Mutual Funds and Index Funds for Investing in Commodities
Although mutual funds cannot be used to invest directly in commodities, they may invest in the shares of companies in commodity related industries, such as energy, agriculture, or mining. Like the stocks in which they invest, mutual fund shares may be affected by factors other than fluctuations in commodity prices, including general stock market fluctuations and company specific factors.
However, there are a small number of commodity indexed mutual funds that invest in futures contracts and commodity linked derivative investments and therefore offer investors more direct exposure to commodity prices.
By investing in mutual funds, investors benefit from professional money management, greater diversification and liquidity. Unfortunately, management fees are sometimes high and some funds may have sales charges.
Use of Commodity Pools and Managed Futures to Invest in Commodities
A commodity pool operator (CPO) is an individual (or limited partnership) that pools investors’ money and then combines it into a pool to invest that money in futures and options contracts. CPOs distribute periodic account statements as well as annual financial reports. They are also required to keep strict records of all investors, transactions, and any additional pools they may be operating.
CPOs typically engage a commodity trading advisor (CTA) to advise them on pool trading decisions. CTAs must be registered with the Commodity Futures Trading Commission (CFTC) and are usually required to undergo a background check before they can provide investment advice.
Investors may decide to participate in a TPO because they have the added advantage of receiving professional advice from a manager. In addition, a pooled structure provides more money and more investment opportunities for the manager. If investors opt for a closed end fund, they all have to contribute the same amount of money.
Wrap Up
There are many different ways for both new and experienced traders to invest in financial instruments that give them access to the commodities markets. Even though commodity futures contracts are the most direct way to take part in changes in the prices of commodities, there are other investments with less risk that can also give you enough exposure to commodities.
In the most basic sense, commodities are known to be risky investment propositions because they can be affected by uncertainties that are difficult, if not impossible, to predict, such as unusual weather patterns, epidemics, and both natural and man made catastrophes. As a result, before investing money, investors should always do their homework and understand the dangers involved.
FAQs
Commodities trading is the purchase and selling of real goods like wheat, gold, oil, and other basic resources. This type of investment entails making predictions about how much certain commodities will cost in the future.
Trading in commodities can be profitable since it enables investors to profit from changes in price on the commodities market. Commodities are unrelated to equities and bonds, adding diversification to a portfolio.
Trading in commodities is very risky because prices can be unpredictable and erratic. Before making an investment, it’s critical to comprehend the dangers involved in trading commodities.
Energy products like oil and natural gas, metals like gold and silver, agricultural goods like wheat and corn, and other raw materials are examples of commodities that can be exchanged.
A broker or trading platform account must be opened in order to begin trading in commodities. You’ll also need to create a trading strategy and conduct market research on the commodities market.
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- U.S – Securities and Exchange Commission – Futures Contract
- Commodity Futures Trading Commission – Seeing Commodity Pools More Clearly
- Commodity Futures Trading Association – Commodity Training Advisors
