A commodity is a basic good used in commerce and one that is interchangeable with other goods of the same type. Commodities are generally raw materials or primary agricultural products that can be bought and sold. Commodities are traded on an exchange and must meet specified minimum standards to qualify for the exchange.
Typical examples of commodities include:
Precious metals such as gold, silver and copper
Wheat and grains
How a commodity works
The purchase and sale of commodities are generally carried out through futures contracts on exchanges that have standards in place for the minimum quality and quantity of the type of commodity being traded.
The Chicago Board of Trade states that one wheat contract is for 5000 bushels and also determines which grades of wheat can be used as part of the trade. Having these standards in place helps ensure that all commodities are of the same quality across producers.
Essentially, commodity prices are determined by supply and demand. Commodity prices usually increase with inflation, making them a popular choice with investors when inflation is expected to rise.
As the demand for goods and services increases, the price of the commodities used to produce these goods and services also increases. This strategy is often classed as a hedge for inflation as an investor in commodities would be hedging against the fall in buying power of the currency.
Equally, when the demand for particular goods and services falls, so can the price of the commodities used to make them.
Types of commodity traders
There are two main types of commodity traders:
Buyers and producers of commodities:
These types of traders use commodity futures contracts for hedging purposes and the way in which they were originally intended to be used. For example, a wheat farmer plants a crop, he then places a hedge against the risk of losing money if the price of wheat decreases before the crop is harvested. This means the farmer can sell wheat futures contracts when the crop is planted and secure a predetermined price for the wheat when it is harvested.
These are traders that trade in the markets with the purpose of capitalizing on the volatile price movements. They have no intention of making or taking delivery of the commodity when the futures contract ends. Trading in this way is often seen as a good way for traders to diversify their investment portfolios and can provide good short-term gains.
Advantages of commodity trading
There are many advantages of commodity trading, such as:
Protection against inflation
Investing in commodities is a good way for investors to protect against increases in inflation. As the rising prices of final goods are inflated so are the prices of the raw materials or commodities that are used to make them.
Hedge against political events
Investors can use commodities to hedge against geopolitical tensions or events such as war, riots or conflict which can disrupt the supply chain and cause a dip in supply. The low supply coupled with a high demand can make the price of commodities surge.
Trading commodities can provide a high amount of leverage, investors may have the options to control a large position on just a 5-10% payment of the contract value as an upfront margin.
Disadvantages of commodity trading
As with all types of investing commodity trading also has its disadvantages, including:
Higher losses through leverage
While leverage can be great when making gains, it can quickly escalate into big losses when the market is moving against you. There is a big risk when using leverage and while gains can be outstanding, losses could dissipate your entire investment.
Markets can be volatile
As the drivers of commodities is supply and demand, they are often considered one of the most volatile assets on the market. Effects from inflation and geopolitical events can also trigger huge spikes or loses.
Do not generate income
Investors looking to create an additional income stream from their portfolio may not want to include commodities, as they do not pay dividends or interest. The return on commodities is based solely on the appreciation of the asset price.