When you buy an ear of corn or a bag of wheat flour from a supermarket, you probably don’t pay much attention to where it was grown or ground. This is because corn and flour are staples.
Commodities are raw materials. They are interchangeable and can be bought and sold at wholesale. Often these raw materials are the building blocks of manufactured products.
Types of goods
Investors classify commodities into two categories: hard and soft. Hard raw materials require mining or drilling to be found. The commodities are farmed or ranched. There are four main types of goods.
1. Agricultural products: Soft raw materials. They include crops like coffee, corn, wheat, soybeans, cotton, and timber.
2. Livestock and meat: Soft raw materials. They include live cattle, beef, pork belly and milk.
3. Energy products: Hard goods. They include crude oil, natural gas, unleaded gasoline, propane, ethanol, and coal.
4. Metals: Hard goods. They include precious metals, such as gold and silver, and industrial metals, such as copper, aluminum, and palladium.
What is commodity trading?
Commodity trading is the buying and selling of these commodities. Sometimes it is the physical exchange of goods. But most often this happens through futures contracts, where you agree to buy or sell a commodity at a certain price on a specified date.
With futures contracts, commodity traders bet on the movement of commodity prices. When you think the price will go up, you buy futures or go long. When you think the price is going to go down, you sell futures contracts or you sell short. While futures contracts can be used to speculate on price changes, they are often used by producers or large industrial consumers as a hedge against price rises or falls, as we will see shortly.
Futures contracts are generally traded on commodity exchanges. The two largest exchanges in the United States are the Chicago Mercantile Exchange and the New York Mercantile Exchange.
Commodities vs stock market
Commodity prices often fluctuate wildly due to changes in supply and demand. For example, when there is a big harvest of a certain crop, the price usually drops. In times of drought, prices often increase for fear of a drop in supply. Likewise, in cold weather the demand for natural gas for heating purposes increases, causing prices to soar as well. But a heat wave during the winter can lower prices.
Yet some commodities are relatively stable, such as gold, which also serves as a reserve asset for central banks. But in general, commodities are significantly more volatile than stocks or bonds.
Some investors are looking for commodities for diversification. Commodities generally have a negative correlation (their prices move in different directions) or low correlation (their prices do not move in tandem) with stocks. For example, oil and stocks tend to have a negative correlation. This means that rising oil prices are traditionally linked to a weaker stock market, and the stock market is often stronger when oil prices are low.
For this reason, commodities are a popular market hedge. Many investors flock to gold during a bear market, for example. Commodities are also a hedge against current inflation. High inflation often causes commodity prices to skyrocket, while stocks and bonds perform better when inflation is lower.
How to invest in commodities
Commodity trading is not the only way to invest in commodities. You can also invest in stocks of companies that produce commodities. Or you can invest in exchange traded funds (ETFs) or mutual funds that track the commodity. Here are four basic ways to invest in commodities.
1. Invest directly in the raw material
If you want to invest by physically buying a commodity, an advantage is that you don’t have to go through a third party. Usually, you can do a simple internet search to find a dealer to sell you a particular good, and when you no longer want it, that dealer will buy it back often. But you need to understand the logistics of delivery and storage.
If you are buying gold it can be relatively straightforward. You can easily find an online coin dealer who can sell you a bar or a coin. You can safely store it and sell it later however you want.
But it gets a lot harder when you try to figure out the delivery and storage of livestock, crude oil, or bushels of corn. For this reason, investing in most physical commodities is usually too much effort for individual investors.
2. Invest in futures
You can trade futures contracts as long as you have a brokerage account that allows it. But futures contracts are largely designed for large companies involved in commodities, rather than individuals.
For example, let’s say you are a corn farmer. You want to be sure that you can get at least the going market price for your crop. So you sell a futures contract by committing to sell 5,000 bushels of corn at $ 4 each in 90 days. You win if the prices go down because you locked in $ 4 a bushel, but you miss out on profits if the prices go up to $ 5.
On the other hand, let’s say you are a food processing company that needs corn to produce cornmeal for food retailers. You don’t want to risk higher prices if there is a smaller crop. So you buy this futures contract for 5,000 bushels of corn at $ 4 each. If the prices go down, you lose because you pay more than the going market price. But if they skyrocket, you’re still only paying $ 4 a bushel.
As an investor, you can also speculate on corn prices. For example, let’s say you buy the same futures contract. You don’t plan to buy 5,000 bushels of corn in 90 days, but you bet the prices of corn will go up and you can sell it for more. Or you can take a short position if you think the prices will go down.
One of the big risks of commodity trading is that the margin requirements are significantly lower than those of stocks. When you trade on margin, you are trading borrowed money, which can amplify your losses. Given the volatility of commodity prices, it is essential that you have enough resources to cover any margin calls, i.e. when your broker asks you to deposit more money.
3. Invest in commodity stocks
Another way to invest in commodities is to buy stocks of the companies that produce them. For example, you can buy mining, oil, or agricultural stocks.
A commodity producing company will not necessarily increase or decrease depending on the raw material it produces. Of course, an oil producing company will benefit from the rise in crude oil prices and suffer from the fall. But what is far more important is how much oil it has in its reserves and whether it has lucrative supply contracts with high-demand buyers.
4. Invest in commodity ETFs and mutual funds
Commodity ETFs and mutual funds provide exposure to commodities for those who do not wish to buy the commodity directly. Commodity funds can invest in physical materials, commodity stocks, futures or a combination. However, commodity funds may not move in line with the price of the underlying asset, which may surprise new investors.
Should we trade raw materials?
Commodity trading is a high risk, high reward business. This can be an effective way to protect your portfolio against a bear market or inflation. But you should only consider it if you have a solid understanding of the supply and demand dynamics of the commodities market. This includes knowledge of historical price trends and what is happening in real time. If you are just starting out, you can reduce your risk by limiting your use of margin.
Much of commodity trading is speculation, not investment. Unpredictable factors such as weather conditions, disease and natural disasters can have a huge impact on commodity prices in the short term. If you are looking to invest in a commodity for the long term, commodity stocks, mutual funds, and ETFs are a better option for most individuals.