Introduction to CommoditiesReading Time: 7 Min Experience Level:Beginner
One might imagine that commodity markets are a haven for high-risk
individuals, and there is some historical truth in that image. However, almost
every type of investor participates in commodity markets.
If when you woke up today, you made a sandwich, drank a cup of
coffee, filled your gas tank, and turned on the AC, guess what? You are already
an influence in the commodity market.
Your everyday life is based on paying for and using commodities.
So, what is a "commodity," and how does commodities trading work? How
do I "invest" in commodities? The following briefly introduces
commodities and a few pointers for investors.
Basics of Commodities and Types of Commodities
Commodities are materials that can be sold, bought, or used to
create an end product that will eventually be consumed or used.
Technically, commodities are raw and unprocessed and could be extracted
from deep underground or plucked from a farm somewhere. When it comes to
trading, a given commodity's size is identical; one bushel of corn is the same
as any other bushel, and one barrel of oil is interchangeable with the next.
Commodities can be categorized into the following primary classes:
Metals, like gold, silver, copper, and platinum
Energy, like crude oil, natural gas, or heating oil
Livestock, like live cattle and lean hogs
Soft commodities, like coffee, cotton, sugar, and cocoa
Grains like corn, wheat, soybeans, and soybean oil
Among all these, crude oil is the most actively traded in the
world. According to Futures Industry Association data, over 4.2 million futures
and options contracts were traded daily in 2017.
Who Trades
Commodities?
Commodity Market
Participants. Who Trades Commodities?
-
Commercials (Hedgers):
These participate in the market for commercial
gain and protection against market price fluctuations—they operate in
producing, processing, exporting, importing, shipping, and handling the commodities.
Example: oil & gas refiners and producers,
miners, grain millers, farmers, and food distributors.
-
Speculators:
Speculators enter the market to profit from the
price of commodities by speculating on the direction of the price within a
specific time frame.
Examples: Hedge funds, banks, and individual
commodity traders.
Futures Exchanges
and Contracts
A big part of commodity trading is in futures contracts.
Futures are agreements between a buyer and a seller where they
agree to buy or sell a specified quantity or contract of a commodity at a
predetermined price and time.
For example, one gold futures contract specified 100 troy ounces
of gold.
What moves commodity
supply and demand. The Fundamentals behind the price movement
-
Economic Growth
Increased economic activity creates more
demand for energy, food, and basic materials, so some commodities benefit in
times and places where economic growth is seen.
-
Weather Conditions
This is a significant factor for most
commodities. For instance, agricultural products can be impacted by floods and
droughts, demand for heating fuel will generally increase during cold snaps, and
storms and hurricanes could stall energy production and shipping of all
products.
-
Wars, Trade Disputes, and geopolitics
Geopolitical events and wars often disrupt
commodity production in certain areas. For example, the war between Russia and
Ukraine resulted in an increase in tens of commodities, including microchips,
fertilizers, food items, and energy products
Some of these factors are hard to anticipate, which often makes the
price of commodities prone to higher volatility than many other asset classes
such as bonds and stocks. This should be taken into consideration when participating
in the commodities market.
How do You Become a
Participant in the Commodities Market?
For individual investors and traders, this does not mean planting
and harvesting your wheat crop or storing your oil barrels.
The following financial instruments allow you access to the commodities
market:
• Futures contracts
• Options on futures: Traders could use call or put options on oil or gold
futures contracts, for example, which gives them the right to buy or sell these
contracts at specific prices before the expiration date of the futures contracts.
• Exchange-traded funds (ETFs). They
are marketable securities that trade like common stocks and can be bought or
sold on an exchange. Many ETFs are linked to a single commodity, a basket of
commodities, or a commodity index.
• Traditional stocks. Many
publicly traded companies have direct exposure to commodities and commodity
markets (miners, oilseed processors, and oil and gas exploration companies, for
example) or indirect exposure (such as farm equipment manufacturers).
