What Are Commodities?
Commodities are types of goods or other items of value that are interchangeable with one another within the same type of commodity. They are fairly uniform within each class of commodity, for instance one bar of fine gold of the same purity will not differ from another of the same purity.
While the quality of a commodity can differ slightly, these differences aren’t significant enough such that quality is going to be a material concern. This sometimes requires that types of commodities be defined a certain way, for instance a certain type of oil, but within that type, one barrel or another isn’t going to really matter.
There are minimum standards of quality that define commodities that are traded on exchanges. This standard is known as basis grade, par grade, or contract grade. When one trades commodities, one need not be concerned about grade since this ensures that it will meet the required standard that is acceptable for exchange as commodities according to the type and grade specified in the contract.
Commodities are used as inputs in business, as would be the case with our example of oil, and even precious metals such as gold are used in industrial processes, jewelry making for instance. Industrial demand need not drive the market though, although it does with most commodities.
The fact that commodities are interchangeable plays an important role in their exchange on financial markets, as this greatly adds to the liquidity and ease of trading of the market. Not all commodities are actual goods, and as long as something meets the condition of uniformity that defines a commodity, it can be traded as one.
Some example of things that aren’t goods that are traded as commodities are currencies and indexes, and this fits the commodities market well since these are both of a uniform nature and are things that investors seek to purchase future contracts on.
Commodities and the Futures Market
While there is a spot market for certain commodities, meaning that they are traded for immediate delivery, trading in commodities generally occurs on the futures market, through futures contracts, where the delivery of the commodity is set to occur at some specified time in the future.
The main purpose of the commodities market is not so much to buy and sell these commodities in general, but to do so at a certain price down the road, which hedges the end users and suppliers of these commodities against the risk of future price fluctuations.
So if a farmer is planting a crop today, he may want to make sure that he gets a certain price for his crop when it is harvested, or a producer of goods may want to lock in a certain price for which he would pay for the goods down the road, so in both cases the parties would engage in futures contracts, either to buy or sell the commodity.
While some commodity futures contracts do involve an actual exchange of the commodity, taking delivery of it, the percentage of futures contracts that actually involve the transfer of the physical commodity is low, and the contracts are generally settled in cash.
This is because the contract generally changes hands a lot of times and those left with the contract may have no interest in exercising it per se, so the parties just settle on the difference in price between the contract and the spot price. Some futures contract do require physical delivery of the commodity though.
Much of what goes on in the commodities market is done by those with no intention whatsoever of ever taking possession of the commodity. Since commodities are so liquid, meaning each type of commodity is so widely traded, this attracts the interest of a lot of financial speculators, investors who are in it to take advantage of the price movements itself with these contracts.
In this sense, commodities contracts can be seen as a sort of derivative, given that a lot of the trading that goes on in the market is based upon the asset but money changes hands independent of the asset changing hands. This would differ from trading stocks or bonds for instance, where you always take delivery of the stock or bond, even if only for a brief time.
In the case of some commodities, things like index futures for instance, well this is the sort of thing that investors do take possession of, baskets of stocks on an index for instance or a certain currency, but with a lot of commodities that are traded, investors never execute the contracts, because they involve goods they have no use for.
Commodities trading can be a lot like trading options, where people buy and sell options without ever having the intention to execute the option, and due to the ease that you can enter and exit positions in the commodities market, there’s no real reason to.
Without this liquidity, in theory anyway, and if one had to take delivery as well, you could be stuck with the physical goods, and instead of getting your capital back, either more or less depending on what you paid and what the goods are worth at the expiration of the contract, you would instead get the oil or the cocoa or what have you.
This never happens in the commodities market because it is so actively traded, as well as being easily purchased on the spot market, and a lot of traders only hold positions for a brief period, and there are a lot of intraday commodity traders, buying and selling during the same day to benefit from price fluctuations.
Holding positions with commodities can also serve to diversify one’s investments, since commodities don’t really correlate that much with other financial investments, such as the stock market, and this is especially true of gold, which tends to have an inverse correlation. So commodities can hedge one’s risk exposure to the market generally.
In addition to trading on the futures market, there is also a forward market for commodities, with the difference being that future contracts are traded on exchanges, where the forward market are futures contracts that are not traded on exchanges.
Ways To Trade in Commodities
Aside from buying and selling commodities contracts, commodity exchange traded funds, or commodity ETFs, are a popular way for individual investors to trade in commodities. This can represent some real advantages to investors who just want to trade in commodities and would prefer others manage things, as is the case with funds in general.
So a commodity ETF would track certain commodities, and they may actually hold the physical goods for speculation purposes, in addition to holding futures contracts, and investors who trade these funds need not be concerned about anything other than just buying and selling the ETF.
ETFs represent a lot of added convenience for individual investors and they are especially beneficial to those who simply don’t have the time to pay as close attention to the commodities market as they need to in order to be a successful commodities trader, so going with a fund instead offers the benefit of professional management, whose goals are aligned with yours.
Commodity ETFs may also deal in derivatives such as futures options, which involve quite a bit more risk than just trading in futures, and this is a form of trading where you really have to know what you are doing to manage the risk. So giving this over to fund managers can clearly be a real benefit with most investors, allowing them to benefit from the addition of these strategies without having to worry too much that the plan will not be executed properly.
However, one may trade on their own in the futures options market, although one has to be careful not to allocate too big a portion of one’s overall portfolio to these options, or options in general, as you can lose up to your entire investment if things don’t go as planned, and you are not skilful or nimble enough.
Those who want to speculate on the commodities market but would rather trade broadly, looking to trade the commodity market itself, can buy and sell commodity indexes, which are baskets of commodities just like a stock index or a bond index are baskets of securities.
Like all financial markets, those who engage in speculation are basing their decisions on being able to determine what the future supply and demand for something will be. In the case of commodities, there are a number of things that affect this, and this isn’t a random thing at all, which is why we do see a lot of speculation in these markets.
So on the one hand you have your primary hedgers, parties that actually provide the baseline supply and demand, the exchange of the commodities themselves, and this is what drives the commodities market. Then you have people who are simply looking to make money off of these markets, the speculators, and this is where investors come in.
The commodities market is much more of a skill based investment than many other forms, as commodities don’t tend to go up over time like stocks do, or deliver income like bonds do. Commodities are pure speculation, looking to judge the future price points of things, but this does provide some nice opportunities to do well if you are either skilled enough or are willing to become skilled enough in trading in the commodities market.