Commodities Trading: An Overview

Commodities are essential elements in most Americans’ daily life. A commodity represents a basic interchangeable good used in business. It means that people can change one with other goods of the same type. Examples of commodities are gold, grains, beef, oil, and natural gas.

For investors, commodities represent a vital way to expand their portfolios, exceeding traditional securities. Some investors also rely on commodities during market volatility because their prices manage to move in opposition to stocks.

In the past, trading with commodities needed a considerable amount of time, money, and expertise. It was also principally limited to professional traders. Today, the situation has changed. Now, there are more options for engaging in the commodity markets.

KEY TAKEAWAYS

• Commodities are sorted into four main categories: agricultural, energy, metal, livestock, and meat.
• Investors diversify their portfolios through commodities outside of traditional securities.
• Commodities seem to be risky investment propositions because uncertainties quickly impact their supply and demand.
• Several ways to invest in this market include futures contracts, options, and ETFs (exchange-traded funds).

A History of Commodities Trading

It is an ancient profession with a history longer than the trading of bonds and stocks. The emergence of most empires was linked to their ability to create elaborate trading systems and promote commodities exchange.

In today’s world, commodities are still exchanged across the globe. It refers to a physical location (where the trading takes place) and legal entities formed to implement the rules for trading contracts and related investment products.

Some exchanges joined or disappeared from the business in recent years. Most of the exchanges offer a few different commodities, while some others specialize in a single group. In the U.S., there is the CME (Chicago Mercantile Exchange), the ICE (Intercontinental Exchange) in Atlanta and the NYMEX (New York Mercantile Exchange). In Europe, there is the LME (London Metal Exchange) as it only deals with metals.

Special Characteristics of the Market

In a broader sense, the basic principles of supply and demand drive the markets. Therefore, any changes in supply directly impact the demand where low supply is equal to higher prices. Hence any significant disruptions in the supply can lead to a spike in the predictable demand for livestock.

Technological advances and Global economic development can also impact prices. For example, the appearance of China and India as essential manufacturing players resulted in the declining availability of metals (such as steel) for the rest of the world.

Types of Commodities

They divide into four categories: energy, metal, livestock and meat, and agricultural.

Energy

Investors interested in entering this market (in the energy sector) should be aware of a couple of things. They should know how economic downturns, any shifts in production enforced by the OPEC (Organization of the Petroleum Exporting Countries), can hugely impact the market prices in the energy sector. Besides that, other factors, such as new technological improvements in alternative energy sources (solar energy, wind power, biofuel, etc.), intend to replace crude oil as a primary energy source.

Metals

Metals include silver, gold, platinum, and copper. Some investors might decide to invest in precious metals (especially gold because it has a reliable status, dependable metal conveyable value) during market volatility or bear markets. Some investors might also invest in valuable metals as a hedge against high inflation periods or currency devaluation.

Agriculture

Agricultural commodities are wheat, corn, soybeans, rice, cocoa, coffee, cotton, and sugar. In the agricultural sector, grains might be quite volatile during summer or any period of weather-related transitions. For investors interested in the agricultural sector, limited agricultural supply combined with population growth can benefit from rising agricultural commodity prices.

Using Futures to Invest in Commodities

With a futures contract, investors can buy or sell a particular commodity asset at a specified time at a predetermined price in the future. The buyer of a futures contract is obligated to purchase and receive the commodity once the futures contract expires. 

The seller of the futures contract is obliged to provide and deliver the commodity when the contract expires. They are available for every category of commodity. Typically, two types of investors participate in the futures markets: commercial or institutional users and speculative investors.

Service providers and Manufacturers use futures contracts in their budgeting process to reduce cash flow-related difficulties and normalize expenses. They might take a position in the markets to reduce their risk of financial loss due to a price change.

The airline sector represents a large industry that needs to secure large amounts of fuel at firm prices for planning purposes. Because of that, airline firms engage in hedging with futures contracts. Future contracts enable airline companies to buy fuel at fixed rates for a specified time. This way, they can avoid unexpected volatility for gasoline and crude oil in the market.

Farming co-ops also use futures contracts. Without managing to hedge with futures contracts, any volatility can bankrupt businesses that require predictability of the prices of goods to control their operating expenses.

Livestock and Meat

Direct investment in commodity futures contracts might be risky for inexperienced investors because the markets can be very volatile. Investors should keep in mind that there might be a huge profit potential, but losses also have the potential to be intensified. If a trade goes against investors, they could lose your initial deposit or even more before they manage to close their position.

Most futures contracts offer options for purchasing. Futures options might be a lower-risk plan to join the futures markets. With an option, investors can (it is not the obligation) follow through on the transaction once the contract expires. Therefore, if the futures contract price doesn’t move in the direction investors anticipated, they have limited their loss to the cost of the option they purchased.

The Bottom Line

Beginner and experienced traders have multiple options for investing in financial instruments to access the commodity markets. While commodity futures contracts provide the most straightforward way to participate in the price movements, additional types of investments with less risk also offer sufficient opportunities for commodities exposure.

In the most basic sense, commodities are risky investment propositions. They can be affected by changes that are difficult to predict, including epidemics, weather changes, and all types of disasters.