Published by FrankNez Team.
Commodities trading goes back further in history than trading stocks and bonds.
Commodities are simply goods that can be exchanged for money or other goods.
In other words, they are the heart of the market – the stuff that gets bought and sold.
The commodities market runs on the basic principle of supply and demand.
Since prices of a given type of commodity fluctuate in response to market forces – including anything from natural disasters to the COVID-19 pandemic – commodities can be a riskier investment option than stocks unless you have enough expertise and resources, making it a historically more prohibitive investment option for individuals.
Keep reading to learn more about investing in commodities and your options for getting started.
Commodities Trading Basics
What is commodities trading?
Commodities trading refers to the practice of buying and selling goods at agreed upon prices.
A commodities exchange may refer to the exchange of the goods themselves, or to regulatory bodies that facilitate commodities exchanges through the enforcement of contractual and legal rules, such as:
- Chicago Mercantile Exchange (CME)
- New York Mercantile Exchange (NYMEX)
- Intercontinental Exchange (ICE)
- Kansas City Board of Trade
- London Metal Exchange (LME)
Who engages in commodities investment?
Historically, commodities trading has been reserved for commercial or institutional producers or consumers.
Think farm owners selling crops or airlines buying jet fuel.
Other commercial or institutional investors may not be involved in the direct production or consumption of goods but look to investment in commodities as a way to diversify their portfolios or hedge against the volatility of other investments, such as stocks.
In fact, because commodities and stocks tend to have an inverse relationship, many investors will put money in commodities like gold during bear markets, periods of high stock market volatility, or times of high inflation.
Finally, individual investors can also profit on commodities through speculation.
Because speculating on commodity prices requires a high level of expertise across many fields – including macroeconomics, microeconomics, and the specifics of a given industry and commodity – this can be an expensive and risky investment option for individuals.
What are the risks of commodities investment?
It’s important to note that commodities investment comes in many forms with different levels of risk.
By far the riskiest options for individual investors are direct investment and futures contracts, which will be explained later in this article.
However, all commodities trading is subject to the effects of market forces on supply and demand, and thus the effects of supply and demand on commodity prices.
One major risk of direct commodities trading is that small price fluctuations can amplify your gains or losses exponentially, meaning that you could gain significantly more than you invested – but you can also lose much more too.
The Commodity Futures Trading Commission – a regulatory body that registers commodities trading professionals, among other things – warns that “many individuals lose all of their money” in futures markets.
Types of Commodities
Commodities are divided into the following four categories:
1. Metals
Metals include gold, copper, palladium, etc.
As mentioned, gold and silver are popular investments for those hedging against losses due to stock market volatility.
According to the CFTC, metals are typically most impacted by industrial and macroeconomic factors.
2. Energy
This category includes a broad range of natural resources, including natural gas.
Risk factors usually relate to supply and storage availability, or actions made by regulatory bodies like the Organization of Petroleum Exporting Countries (OPEC).
3. Livestock and Meat & 4. Agriculture
Both livestock/meat and agriculture are typically affected by weather patterns, but can also be affected by natural disasters, epidemics and pandemics (human and animal), or other global supply chain issues.
Options for Investing in Commodities
Futures Contracts
A futures contract is a contract in which one party agrees to purchase and receive a given commodity at a certain price and at a certain time.
For example, a developer might agree to buy lumber at a certain price for a certain number of months.
If the market price falls below the contract price before the contract is up, the developer will lose money.
But if prices rise beyond the agreed upon price, the developer is locked into the better deal.
Futures trading – or the buying and selling of futures contracts – is the most common way to directly invest in commodities.
It’s also expensive and can be risky.
As mentioned, it is typically reserved for commercial or institutional investors who need to be sure they can buy the goods necessary for the operation of their businesses at prices that are protected from volatility in the market.
Otherwise, futures trading is done by large organizations or individuals to profit on price fluctuations or hedge against other investments.
Futures trading usually requires a brokerage account (which will charge brokerage fees), as well as deposits for the commodity investments themselves.
Sometimes investors even receive a “margin call” from their broker requiring them to deposit more money than what they initially paid.
With some exceptions, commodity futures and options must be traded through an exchange by professionals or firms who are registered with the CFTC.
As you can see, futures trading can be prohibitive to individual investors and should be approached with caution.
Stocks
Stocks can be an alternative option for investing in commodities.
With this strategy, an investor buys stocks in a company that deals with the commodity they’re interested in.
However, this is fundamentally different from investing directly in the commodity.
With futures contracts, an investor is directly purchasing ownership of the commodities themselves, while with stocks an investor is simply buying a share of an entity that deals with the commodity.
As Investopedia points out, stocks are affected by different factors than commodity prices, including internal company factors that have nothing to do with the macroeconomic factors impacting the commodities in question.
ENTs, ETPs, ETFs and Mutual Funds
Like stocks, ENTs, ETPs, ETFs and mutual funds can be less volatile investment options than direct commodities trading.
These options come with risks similar to those of stocks, but also similar advantages: good money management (if you’re using a broker), diversification opportunities, and the ability to make a profit on commodities without losing lots of money on speculation.
Commodity Pooling
Sometimes, a group of investors will pool their investment and go in on a futures contract together.
This type of arrangement is typically facilitated by a professional commodity pool operator (CPO), who will hire a commodities trading adviser (CTA) registered by the CFTC.
Pooling resources can offer the advantage of lower upfront investments from all parties, and the CTA helps make money management easier.
What to Consider Before Investing in Commodities
The CFTC suggests that investors consider the following before investing in commodities:
- Your financial experience, goals and financial resources
- How much you can afford to lose (beyond your initial investment)
- All of the obligations of your contract(s)
- The risk disclosure documents the broker is required to provide
- Whom to contact with problems or questions
As with any prospective investment, do your research carefully and thoroughly before making any purchase, and take a look at some of the resources available from the CFTC.
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