A commodity is a good used in trading that can be exchanged for other commodities of the same kind. Commodities are usually used as a production input for other goods or services. Therefore, they usually refer to raw materials used to make finished products. The product, on the other hand, is a finished good that is sold to the consumer.
The quality of any given commodity may vary slightly, but is essentially consistent from manufacturer to manufacturer. When trading on the stock exchange, commodities must also meet certain minimum requirements, also called basis grade.
Commodities are the raw inputs used in the production of goods. They can also be a staple food, for example certain agricultural products. An important feature of the commodity is that it does not matter if it comes from one manufacturer and the same commodity from another. An oil drum is basically the same product regardless of manufacturer. The same applies to a bushel of wheat or a ton of ore. However, the quality and characteristics of a given commodity often vary greatly depending on the manufacturer (eg Coke vs Pepsi).
Some traditional examples of commodities are grain, gold, beef, oil and natural gas. More recently, the definition has been expanded to include financial products such as currencies and indexes. Technological developments have also made it possible to replace new types of products on the market. For example, cell phone minutes and bandwidth.
Commodities can be bought and sold as financial assets on specialized exchanges. There are also well-developed derivatives markets where you can buy contracts for these commodities (such as forwards, futures and options). Some traders believe that investors should own at least part of a well-diversified portfolio of commodities because they are not highly correlated with other financial assets and can act as a hedge against inflation.
Types of commodities
Hard commodities are usually classified as mineable or extracted from the earth. These can be metals, ores and oil derivatives (energy).
Soft commodities, on the other hand, refer to what is grown, such as agricultural products. These include wheat, cotton, coffee, sugar and soy. The most important commodities are:
1. Agriculture
Agricultural products include products such as coffee, corn, which is an important food for livestock and people, sugar, soybeans, whose oil is used to make crackers, bread, cookies and crackers, and wheat, which is one of the most important foods crops in the world.
2. Energy
Energy products include crude oil used in transportation and plastics production, natural gas used for electricity generation, and gasoline used as a power source for light-duty trucks and cars.
3. Metals
Metals include gold and silver which are used in jewelry and many other industrial purposes and copper, the most common form of electrical wiring.
How do you trade or invest in commodities?
There are several ways for individual investors to gain exposure to commodities:
- Forward contracts. A forward contract is an agreement to buy or sell a specified quantity of a commodity at a specified price in the future. If the price of the futures contract rises, the buyer can sell it and make a profit. However, the seller of a futures contract can make a profit if the price falls (this is called a short sale). While most commodity futures contracts technically allow for physical delivery, nearly all contracts are settled before the contract’s expiration date.
- Options on futures. Many futures exchanges trade in calls or buys based on crude oil or gold, for example. These contracts give the option buyer the right, but not the obligation, to buy or sell a specific futures contract at a specified price on or before the expiration date.
- Exchange Traded Funds (ETFs). ETFs are transferable securities that trade like common stocks and can be bought or sold on exchanges. Many ETFs are tied to a single commodity, a basket of commodities, or a commodity index.
- Traditional stocks. Many publicly traded companies have direct exposure to commodities and commodity markets (such as miners, grain processors, and oil and gas exploration companies) or indirect exposure (such as farm equipment manufacturers, seed companies, or oil service companies).
Commodities can be viewed as “alternative” investments that are believed to be uncorrelated or barely correlated with stocks and bonds. When stocks fall or rise sharply, alternative assets can move in the opposite direction or in the same direction, but to a lesser extent. This potential mismatch between stocks and bonds is one reason why alternative investments can help diversify a portfolio, although diversification does not eliminate the risk of investment losses.
In general, commodities provide a fascinating view of the global economy, and following these markets can provide information or ideas for an investment strategy (or simply keep the investor informed). But these unique assets carry unique risks, so a savvy investor shall proceed with caution.
