Commodity markets may conjure a freewheeling world of high rollers living hard and taking outsized risks, and there’s some historical truth in that image. But in a sense, all investors—whether big, small, or in between—participate in the commodity markets. If today, for example, you ate breakfast, made a cup of coffee, adjusted your thermostat, or filled your gas tank, guess what? You’re already a commodities “player.”
Commodities affect our lives every day, in other words. So, just what is a “commodity,” and how does commodities trading work? How do I “invest” in commodities? The following offers a brief introduction to commodities and a few pointers for investors.
Basics of Commodities and Types of Commodities
Simply defined, commodities are raw or unprocessed materials that can be bought or sold and are used to make something else that eventually is consumed. For trading purposes, a given commodity typically is interchangeable—one bushel of corn is considered pretty much the same as any other. Many commodities are pulled from deep underground or plucked from right on top of the ground.
Major commodity categories include:
- Energy (crude oil, gasoline, heating oil, natural gas)
- Grains (corn, soybeans, soybean meal, soybean oil, wheat)
- Livestock/meats (feeder cattle, live cattle, lean hogs)
- Metals (copper, gold, palladium, platinum, silver)
- “Softs” (cocoa, coffee, cotton, orange juice, sugar)
- Other (lumber)
Of these commodities, crude oil is the world’s most actively traded. On average, over 4.2 million futures and options contracts traded each day in 2017, according to Futures Industry Association data.
Who Trades Commodities?
There are two broad types of commodity market participants:
- Hedgers (aka “commercials”). These are businesses that are actually producing, shipping, processing, or otherwise handling the commodities in question. They include oil and gas producers and refiners, miners, grain millers, farmers, and meatpackers.
- Speculators. These include banks, hedge funds, and individuals who trade commodities. They speculate that the price of a commodity will go up or down within a certain time frame, and they place trades with the aim of turning a profit.
What about Futures Contracts and Futures Exchanges?
Both play a major part in the commodities markets. Futures contracts are standardized agreements between buyers and sellers where both parties agree to buy or sell a specific amount of a particular commodity at a predetermined price, at a specific date in the future. For example, one crude oil futures contract specifies 1,000 barrels of West Texas Intermediate crude, the U.S. benchmark.
Futures exchanges, much like their counterparts in stocks, provide a centralized (and now mostly electronic) forum for hedgers and speculators to conduct business. Both hedgers and speculators are essential to a functioning, “liquid” market, where willing buyers can find willing sellers, and vice versa.
“Hedgers and speculators go hand in hand—if you took one away, there simply would be no market,” Chicago-based CME Group, which runs several futures exchanges, says on its website. “Hedgers transfer risk, and speculators absorb that risk. It takes both types of traders to bring balance to the market and keep trades moving back and forth.”
What “Fundamentals” Move Commodity Markets?
Weather is a major factor for many commodities. Droughts and floods hurt farmers’ harvests, cold snaps boost heating fuel demand, hurricanes disrupt oil production and shipping, and so on. Commodity market professionals constantly keep an eye on the weather forecasts. Wars, trade disputes, and other geopolitical developments can also affect commodity markets.
Altogether, these factors are difficult to predict with accuracy, which could make commodity markets prone to sharp, sudden price swings—or greater “volatility,” as compared to traditional stocks and bonds. Investors should carefully consider their appetite for risk.
How Do You Trade or Invest in Commodities?
For individual investors, there are several avenues into the commodities markets that don’t involve planting your own wheat or buying your own drilling rig. These include:
- Futures contracts. As described previously, 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 rises, the buyer, in theory, can profit; in contrast, the seller of a futures contract profits if the price goes down (this is known as going short). In futures markets for retail traders, actual “delivery” of a commodity rarely happens; usually contracts are “closed out” prior to expiration.
- Options on futures. Put or call options based on crude or gold, for example, are traded on many futures exchanges. These contracts confer the holder 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). ETFs 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).
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