Introduction to Commodities

Reading 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).