Commodities markets can conjure up a freewheeling world of big players living hard and taking disproportionate risks, and there is some historical truth to this picture. But in a sense, all investors, whether large, small or middle-of-the-road, participate in commodity markets. If today, for example, you had breakfast, made a cup of coffee, adjusted your thermostat or filled your gas tank, guess what? You are already a commodity “player”.
Commodities affect our lives every day, in other words. So what is a “commodity” and how does commodity trade work? How to “invest” in commodities? The following provides a brief introduction to commodities and some tips for investors.
Raw material basics and types of raw materials
Simply put, commodities are raw or unprocessed materials that can be bought or sold and are used to make something else that is ultimately consumed. For commercial purposes, a given product is usually interchangeable – a bushel of corn is considered pretty much any other. Many commodities are taken from deep underground or picked directly above the ground.
The main product categories include:
- Energy (crude oil, gasoline, fuel oil, natural gas)
- Cereals (corn, soybeans, soybean meal, soybean oil, wheat)
- Cattle / meat (feeder cattle, live cattle, lean pigs)
- Metals (copper, gold, palladium, platinum, silver)
- “Soft” (cocoa, coffee, cotton, orange juice, sugar)
- Other (drink)
Of these commodities, crude oil is the most actively traded in the world. On average, more than 4.2 million futures and options were traded every day in 2017, according to data from the Futures Industry Association.
Who trades commodities?
There are two main types of commodity market participants:
- Hedgers (aka “advertisements”). These are companies that produce, ship, process or otherwise handle the products in question. They include oil and gas producers and refiners, miners, millers, farmers and meat packers.
- The speculators. These include banks, hedge funds and individuals who trade in commodities. They speculate that the price of a product will go up or down within a certain period of time, and they place trades with the aim of making a profit.
What about futures and futures exchanges?
Both play a major role in commodity markets. are standardized agreements between buyers and sellers where both parties agree to buy or sell a specific quantity of a particular product at a predetermined price, on a specific date in the future. For example, a crude oil futures contract specifies 1,000 barrels of West Texas Intermediate crude, the US benchmark.
Futures exchanges, just like their equity counterparts, provide a centralized (and now mostly electronic) forum for speculators and speculators to do business. Hedgers and speculators are essential to a functioning “liquid” market, where willing buyers can find willing sellers, and vice versa.
“Speculators and speculators go hand in hand – if you took one out, there just wouldn’t be a market,” Chicago-based CME Group, which operates several futures exchanges, said on its website. “The hedgers transfer the risk and the speculators absorb the risk. It takes both types of traders to balance the market and keep trading both ways.
What “fundamentals” are driving the commodity markets?
Weather is a major factor for many products. Droughts and floods affect farmers’ crops, cold spells stimulate demand for heating fuel, hurricanes disrupt oil production and shipping, etc. Professionals in the commodities market constantly monitor the weather forecast. Wars, trade disputes, and other geopolitical developments can also affect commodity markets.
Overall, these factors are difficult to predict with precision, which could make commodity markets subject to sharp and sudden price swings or greater “volatility” compared to traditional stocks and bonds. Investors should carefully consider their risk appetite.
How to trade or invest in commodities?
For individual investors, there are several avenues in the commodities markets that don’t involve planting your own wheat or buying your own drilling rig. These include:
- Futures contracts. As described earlier, a futures contract is an agreement to buy or sell a certain amount of a commodity at a certain price in the future. If the price of a futures contract increases, the buyer, in theory, can profit; in contrast, the seller of a futures contract profits if the price drops (this is called a short sale). In futures markets for retail traders, the actual “delivery” of a commodity rarely occurs; generally, contracts are “closed” before expiration.
- Options on futures. Put or call options based on crude or gold, for example, are traded on many futures exchanges. These contracts give the owner the right, but not the obligation, to buy or sell a specific futures contract at a specific price on or before an expiration date.
- Exchange Traded Funds (ETFs). are marketable securities that trade like common stocks and can be bought or sold on a stock exchange. Many ETFs are linked to a single commodity, a basket of commodities, or a commodity index.
- Traditional actions. Many publicly traded companies have direct exposure to commodities and commodity markets (such as miners, oilseed processors, and oil and gas exploration companies) or indirectly (such as agricultural equipment manufacturers).
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