Most of us don’t spend much time thinking about commodities, but they touch nearly every aspect of our lives. Almost everything we use, work with, watch, eat, or wear was made with a commodity or used a commodity in its mining, refining, manufacturing or transportation. Without commodities, modern civilization wouldn’t exist.
Furthermore, when we use products made from commodities, we’re generally unaware of all the commodity transactions that made that product available. From a consumer perspective, it all just happens behind the scenes. Read on to find out what commodities are and how to trade or invest in them.
What is a Commodity?
A commodity is a basic good used in trade that is interchangeable with equivalent goods of the same type. A commodity is also a raw product or a product that has undergone a minimum level of refinement to be marketable. Examples of commodities include crude oil, gold, silver, wheat, etc.
There may be some slight variances in quality among commodities, although those of the same grade are considered to be the same and therefore interchangeable. One troy ounce of 99.5% pure gold or a bushel of soft red winter wheat is pretty much the same as the next, regardless of who produced it or where it was produced.
Also, a bushel of wheat used to be a volume measurement, but it is now a weight measurement among commodity traders, so you need to get very clear about exactly what commodity and how much of it you are buying or selling as a commodity trader.
How are Commodities Traded?
Ideally, commodity markets should be highly liquid and have numerous buyers and sellers so that commodity prices can be more closely matched to their actual market value. Smaller or limited markets can hold buyers or sellers hostage to unfavorable pricing and can even result in market corners. Larger markets with more participants generally offer more liquidity, so they can absorb bigger transactions without shifting the price as much.
Commodities are traded on futures exchanges where buyers and sellers come together to make transactions in commodities grouped by quality grade, in agreed-upon quantities and for delivery on standardized dates.
In the U.S., the four leading commodity futures exchanges are operated by CME Group to create the world’s leading commodity derivatives marketplace. They are the Chicago Mercantile Exchange (CME), the Chicago Board of Trade (CBOT), the New York Mercantile Exchange (NYMEX) and the Commodity Exchange, Inc. (COMEX).
Commodities are traded as futures contracts. As the name suggests, these are agreements to take delivery of a commodity at a specified price on a specific date in the future. Trading is open to producers who mine or farm the commodity, to industrial concerns that require the commodity for business purposes, and to speculators who believe the price of a commodity will go up or down in the future.
For industrial participants, commodities futures are often used as a way to stabilize their production costs. For example, if you’re a cereal manufacturer, constant fluctuation in the price of wheat or corn can create cash flow challenges and erratic profit performance.
For traders, the value in the commodities futures contract isn’t in the product itself because the average speculator has no use for large quantities of wheat, corn, oil, live cattle or any other commodity. The value of trading commodities lies in the difference between the price at which the futures contract was purchased and the price at which the contract is resold, or the price where it was sold and then repurchased.
While commodities are available for trading on major futures exchanges and at some online brokers using contracts for difference (CFDs), traditional commodities trading can be a high maintenance activity due to the need to track prices and trade out of contracts before settlement. One way to simplify matters is using commodity ETFs.
An ETF is an exchange-traded fund you can purchase via a stockbroker just like shares in any stock. A commodity ETF specializes in one type of commodity or sometimes a group of related commodities. This allows traders or investors to gain exposure to commodities markets without many of the risks and inconveniences commonly associated with traditional commodities futures trading.
A commodities ETF investor invests in shares of contracts or underlying assets purchased by the fund. Commodity ETFs do not require margin accounts, because the investor buys shares in the ETF and not the contracts themselves. ETFs also provide investors with the opportunity to go long a commodity without ever taking possession of the commodity or having to roll out futures contracts, which is very convenient.
Best ETF Brokers
Commodities Price Performance
Pricing can be very volatile for commodities — and volatility creates both risk and opportunity for traders and investors. Commodity prices can also show prolonged trends and be subject to fundamental factors that require close monitoring like weather and natural disasters.
As an example of commodity price performance, the first gold ETFs reached the market in the early 2000s, promising to track the price of gold. Gold subsequently tripled in price, dwarfing the gains seen by broad market investments like S&P 500 Index funds. Buying shares of those early gold ETFs would have made an excellent investment.
Commodities are everywhere, and technological advances that use them can shift their prices considerably. Many of the ideas that seem futuristic now may become larger parts of our lives and require more of the commonly traded commodities sold relatively cheaply today. Also, the use of polluting energy products made from fossil fuels currently seems likely to fall over time, as more renewable replacements become available and more widely used.
New commodities may also arise and take the place of others now in the market. Diets may also shift as the adverse or favorable health impact of certain foods becomes better understood, resulting in less demand for some food commodities and greater demand for others.
One thing that seems certain is that there will always be commodities to trade. This will continue to create opportunities for those with a pulse on market demand and value who are willing to take the risks involved.
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