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Commodities are one of the major asset classes along with stocks and bonds. Most investors will run across the term “commodity” at some point in their investment research. Companies rely on commodities to run their businesses, but commodity investing is usually not appropriate for individual investors.
If you’re interested in learning more about this asset class, here is everything you need to know about commodities.
What is a commodity?
Commodities are basic goods, from soybeans to oil. One of the basic qualities of commodities is that they are interchangeable with other commodities of the same type. The 1936 Commodity Exchange Act goes over what commodities are and how they are regulated by the U.S. government.
Commodity Definition A commodity is a basic good that is exchangeable (or fungible) with other commodities of the same kind. Most often, these goods are produced by the earth and include oil, gas, wheat, soybeans, corn, gold, copper, and so on. Commodities are classified by grades, and those within the same grade are interchangeable. For example, corn crops from the same grade can be evenly exchanged regardless of which farmer produced the good.
Unlike other products such as cars or electronics, commodities are considered the same no matter the origin. A bushel of soybeans is the same no matter which farmer brought it to the market.
Commodities that are traded on the exchange must meet the minimum accepted standard, known as a basis grade. This is critical for maintaining uniformity within the commodity market.
There are many different types of commodities. They are separated in different categories and by type to make it easier to buy, sell, and trade them.
Types of commodities There are two different types of commodities: soft and hard commodities. Soft commodities are agricultural products such as corn, soybeans, coffee, sugar, wheat, and so on. Livestock, such as cattle is also considered a soft commodity. Hard commodities are products that come from the earth, such as gold, copper, oil, and so on. They are typically natural resources that are mined rather than grown.
One of the main reasons that commodities are so volatile is because of supply and demand economics. For example, if the weather is cold, the price of natural gas tends to go up to account for the increased demand. When the weather starts warming up, there will be less demand for heating so natural gas prices will go down.
Or if there is a big harvest of corn or soybeans, the price for these commodities goes down because of the increased supply. However, in the case of a drought, the price will increase to account for the smaller than expected supply.
While certain commodities such as crops, oil, and gas tend to be more volatile, others show more stability. This is the case with gold, which can be used as a buffer against volatility and a hedge against inflation.
How to invest in commodities
There are several ways to invest in commodities:
Acquiring the commodity directly
Investing using commodity futures contracts
Purchasing stocks of companies that produce commodities
Buying shares of commodity exchange-traded funds (ETFs)
Buying the commodity directly requires a high level of logistics, since you have to find a way to transport it and store it. If you end up selling it, you have to find the buyer and figure out how to deliver it. Most investors are not equipped to buy and sell bushels of soybeans or heads of cattle.
Futures contracts are another way to invest in commodities but require using a brokerage account or going through a stock broker. These contracts make the buying and selling of commodities a little easier and standardize the terms such as the price of the commodity and the time frame to buy it or sell it.
The simplest way for most investors to gain exposure to commodities is via ETFs or by buying individual stocks of companies that produce commodities. For example, if you’re looking to invest in crude oil, you can buy stocks in a company that drills for oil. ETFs, on the other hand, allow you to invest in a variety of companies or physical commodities through investor shares.
The commodity market explained
Commodities are bought, sold, and exchanged on the commodity market. The price for each commodity can change daily and can be very volatile. This is one of the reasons that gas prices often fluctuate.
Because the price of a commodity can change from day to day, it can make it difficult on farmers as well as consumers. When farmers plant crops such as soybeans or wheat, they don’t know what the price for it will be come harvest time. The U.S. government smooths out some of the uncertainty by offering farm subsidies.
A farmer can also hedge his bets on the price of his crop, such as corn, by pre-selling it on the futures market. This will lock in the current price for the commodity, so when the time comes to sell, the value of the crop is already established. If the price of corn drops in this time period, the farmer is protected. However, if it goes up, the farmer will still get a lower price based on his futures contract. Futures contracts are agreements to buy or sell a commodity on a specific date at a particular price.
Airlines may want to buy large quantities of fuel using futures contracts to smooth the volatility curve inherent with the commodity. Since fuel prices can change from day to day, locking in the price can help with planning for future expenses.
The most common commodities on the market include oil, gas, heavy metals, and agricultural products. Since they are difficult to transport, they are traded via futures contracts.
Companies, farmers, investors, speculators, consumers and so on buy and sell commodities via futures contracts. This process takes place via exchanges that enforce standards about the minimum quality and quantity of the traded commodity.
How does commodity trading work?
Most commodities are traded via exchanges such as the New York Mercantile Exchange (NYMEX), the Chicago Board of Trade (CBOT), and the Minneapolis Grain Exchange (MGE).
Each exchange specializes in the types of commodities that can be traded. Some focus on agricultural commodities while others trade in natural resources such as oil and metals.
Let’s say you own a bakery and need to buy wheat for bread and other products. Rather than going door-to-door to talk to farmers about their crops, you can head to a commodities broker. The broker will help you purchase commodity contracts for the wheat you need for the bakery.
Each wheat contract must be 5,000 bushels and needs to specify the grade of wheat. Prices are listed in cents per bushel and include the date of physical delivery for the wheat.
Commodity traders come in different types: producers, buyers, and speculators. Producers of commodities include farmers, mining companies, cattle ranchers, and so on. They make the actual commodity named in the futures contract.
Buyers of commodities take delivery of the commodity in the futures contract. An example would be bakeries buying wheat, corn or other products needed for production; a coffee roaster buying coffee beans in bulk; or airlines buying fuel.
Speculators, on the other hand, don’t make or use the commodity names in the futures contract. Their sole goal is to profit from the volatile price movement of commodities. Because of the erratic nature of commodity trading, they are a favorite of intraday traders.
Some portfolio managers and brokerages use index futures to offset risks in other areas. Commodities can also be an effective way to diversify an investment portfolio of stocks and bonds. However, due to their complicated nature, they are generally considered inapproriate for the average investor.
H2 Commodity indexes Another way to invest in commodities is through commodity indexes. A commodity index tracks a group of commodities including their price and investment return performance. Since commodity indexes are often traded on exchanges, they are an easier entry point into commodities without going the futures contract route.
These indexes are similar to stock indexes and are traded much the same way. Their price fluctuates based on the value of the underlying commodities.
Some indexes include only one type of commodity such as natural resources; others consist of different types of commodities ranging from copper to soybeans. In addition, certain indexes are equally weighted across the board so each commodity makes up the same percentage of the index. Others put heavier weight on specific commodities such as agricultural crops like corn and wheat.
One of the big differences between a commodity index and a securities index is the total return. The price performance of the commodities in the index is the determining factor of the total return of the commodity index.
Unlike securities, which pay interest, dividends, and capital gains, commodities do not. The commodities investment performance is the sole determining factor on the return on investment of the index.
If there is no upward movement in the price of the commodity, investors end up with zero return on their investments. With stocks and bonds, even if the price of the stock remains flat, the interest and dividends will ensure the investment increases in value.
Commodities and inflation
Unlike stocks and bonds, commodity prices move up with inflation. High inflation usually results in strong performance on the commodities front while it can erode the value of securities. However, this does not remove the underlying volatility of the commodities market.
Since commodities are tied to inflation, they can be used as a hedge against declining currency value. As the demand for goods and services goes up so does the value of the underlying commodities used to produce those goods and services.
This is one of the reasons why portfolio and fund managers use commodities as a way to balance out stocks and bonds within a portfolio. When stocks and bonds go down in value, commodities tend to go up, offsetting some of the losses and providing and inflation hedge.
Commodities are one of the most volatile asset classes and thus not appropriate for the majority of investors. They carry a higher risk than most other equity investments such as stocks and bonds.
You may have bought a commodity as a hedge against inflation without even realising it. For example, some investors buy bars of gold or gold coins as a way to offset inflation risk. (While gold can also be volatile, it tends to fluctuate less than other commodities.)
The bottom line on commodities
While it’s important to understand what commodities are and the role they play in the market overall, they are not considered an appropriate investment vehicle for new investors. Most investors will benefit from a balanced portfolio of stocks and bonds such as the one offered by Wealthsimple Invest.
One way to invest in commodities without going the futures contract route is by buying stocks for companies that produce a certain commodity. Another option is by investing in index funds composed of a basket of commodities.
Portfolio and fund managers use commodities to balance out equity investments such as stocks and bonds and to hedge against inflation. However, most investors lack the necessary education to evaluate commodity risk and should focus on building a diversified portfolio instead.
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