Commodities are an important aspect of most American's daily life. A commodity is a basic good used in commerce that is interchangeable with other goods of the same type. Traditional examples of commodities include grains, gold, beef, oil, and natural gas.

For investors, commodities can be an important way to diversify their portfolio beyond traditional securities. Because the prices of commodities tend to move in opposition to stocks, some investors also rely on commodities during periods of market volatility.

In the past, commodities trading required significant amounts of time, money, and expertise, and was primarily limited to professional traders. Today, there are more options for participating in the commodity markets.

Key Takeaways

  • Commodities that are traded are typically sorted into four categories broad categories: metal, energy, livestock and meat, and agricultural.
  • For investors, commodities can be an important way to diversify their portfolio beyond traditional securities.
  • In the most basic sense, commodities are known to be risky investment propositions because their market (supply and demand) is impacted by uncertainties that are difficult or impossible to predict, such as unusual weather patterns, epidemics, and disasters both natural and man-made.
  • There are a number of ways to invest in commodities, such as futures contracts, options, and exchange-traded funds (ETFs).

A History of Commodities Trading

Trading commodities is an ancient profession with a longer history than the trading of stocks and bonds. The rise of many empires can be directly linked to their ability to create complex trading systems and facilitate the exchange of commodities.

In modern times, commodities are still exchanged throughout the world. A commodities exchange refers both to a physical location where the trading of commodities takes place and to legal entities that have been formed in order to enforce the rules for the trading of standardized commodity contracts and related investment products.

Some commodities exchanges have merged or gone out of business in recent years. The majority of exchanges carry a few different commodities, although some specialize in a single group. In the U.S., there is the Chicago Mercantile Exchange (CME), the New York Mercantile Exchange (NYMEX), the Intercontinental Exchange (ICE) in Atlanta, Georgia, and the Kansas City Board of Trade. In Europe, there is the London Metal Exchange (LME). As its name implies, the London Metal Exchange only deals with metals.

Special Characteristics of the Commodities Market

In the broadest sense, the basic principles of supply and demand are what drive the commodities markets. Changes in supply impact the demand; low supply equals higher prices. So, any major disruptions in the supply of a commodity, such as a widespread health issue that impacts cattle, can lead to a spike in the generally stable and predictable demand for livestock.

Global economic development and technological advances can also impact prices. For example, the emergence of China and India as significant manufacturing players (therefore demanding a higher volume of industrial metals) has contributed to the declining availability of metals, such as steel, for the rest of the world.

Types of Commodities

Commodities that are traded are typically sorted into four categories broad categories: metal, energy, livestock and meat, and agricultural.

Metals

Metals commodities include gold, silver, platinum, and copper. During periods of market volatility or bear markets, some investors may decide to invest in precious metals–particularly gold–because of its status as a reliable, dependable metal with real, conveyable value. Investors may also decide to invest in precious metals as a hedge against periods of high inflation or currency devaluation.

Energy

Energy commodities include crude oil, heating oil, natural gas, and gasoline. Global economic developments and reduced oil outputs from established oil wells around the world have historically led to rising oil prices, as demand for energy-related products has gone up at the same time that oil supplies have dwindled.

Investors who are interested in entering the commodities market in the energy sector should also be aware of how economic downturns, any shifts in production enforced by the Organization of the Petroleum Exporting Countries (OPEC), and new technological advances in alternative energy sources (wind power, solar energy, biofuel, etc.) that aim to replace crude oil as a primary source of energy, can all have a huge impact on the market prices for commodities in the energy sector.

Livestock and Meat

Agricultural commodities include lean hogs, pork bellies, live cattle, and feeder cattle.

Agriculture

Agricultural commodities include corn, soybeans, wheat, rice, cocoa, coffee, cotton, and sugar. In the agricultural sector, grains can be very volatile during the summer months or during any period of weather-related transitions. For investors interested in the agricultural sector, population growth–combined with limited agricultural supply–can provide opportunities for profiting from rising agricultural commodity prices.

Using Futures to Invest in Commodities

One way to invest in commodities is through a futures contract. A futures contract is a legal agreement to buy or sell a particular commodity asset at a predetermined price at a specified time in the future. The buyer of a futures contract is taking on the obligation to buy and receive the underlying commodity when the futures contract expires. The seller of the futures contract is taking on the obligation to provide and deliver the underlying commodity at the contract's expiration date. Futures contracts are available for every category of commodity. Typically, there are two types of investors that participate in the futures markets for commodities: commercial or institutional users of the commodities and speculative investors.

Manufacturers and service providers use futures contracts as part of their budgeting process to normalize expenses and reduce cash flow-related headaches. Manufacturers and service providers that rely on commodities for their production process may take a position in the commodities markets as a way of reducing their risk of financial loss due to a change in price.

The airline sector is an example of a large industry that must secure massive amounts of fuel at stable prices for planning purposes. Because of this need, airline companies engage in hedging with futures contracts. Future contracts allow airline companies to purchase fuel at fixed rates for a specified period of time. This way, they can avoid any volatility in the market for crude oil and gasoline.

Farming cooperatives also utilize futures contracts. Without the ability to hedge with futures contracts, any volatility in the commodities market has the potential to bankrupt businesses that require a relative level of predictability in the prices of goods in order to manage their operating expenses.

Speculative investors also participate in the futures markets for commodities. Speculators are sophisticated investors or traders who purchase assets for short periods of time and employ certain strategies as a way of profiting from changes in the asset's price. Speculative investors hope to profit from changes in the price of the futures contract. Because they do not rely on the actual goods they are speculating on in order to maintain their business operations (like an airline company actually relies on fuel), speculators typically close out their positions before the futures contract is due. As a result, they may never take actual delivery of the commodity itself.

If you do not have a broker that also trades futures contracts, you may be required to open a new brokerage account. Investors are also typically required to fill out a form that acknowledges that they understand the risks associated with futures trading. Futures contracts will require a different minimum deposit depending on the broker, and the value of your account will increase or decrease with the value of the contract. If the value of the contract decreases, you may be subject to a margin call and required to deposit more money into your account in order to keep the position open. Due to the high level of leverage, small price movements in commodities can result in either large returns or large losses; a futures account can be wiped out or doubled in a matter of minutes.

There are many advantages of futures contracts as one method of participating in the commodities market. Analysis can be easier because it's a pure play on the underlying commodity. There's also the potential for huge profits, and if you are able to open a minimum-deposit account, you can control full-size contracts (that otherwise may be difficult to afford). Finally, it easy to take long or short positions on futures contracts.

Because the markets can be very volatile, direct investment in commodity futures contracts can be very risky, especially for inexperienced investors. The downside of there being a huge potential for profit is that losses also have the potential to be magnified; if a trade goes against you, you could lose your initial deposit (and more) before you have time to close your position.

Most futures contracts offer the possibility of purchasing options. Futures options can be a lower-risk way to enter the futures markets. One way of thinking about buying options is that it is similar to putting a deposit on something instead of purchasing it outright. With an option, you have the right–but not the obligation–to follow through on the transaction when the contract expires. Therefore, if the price of the futures contract doesn't move in the direction you anticipated, you have limited your loss to the cost of the option you purchased.

Using Stocks to Invest in Commodities

Many investors who are interested in entering the market for a particular commodity will invest in stocks of companies that are related to a commodity in some way. For example, investors interested in the oil industry can invest in oil drilling companies, refineries, tanker companies, or diversified oil companies. For those interested in the gold sector, some options are purchasing stocks of mining companies, smelters, refineries, or any firm that deals with bullion.

Stocks are typically thought to be less prone to volatile price swings than futures contracts. Stocks can be easier to buy, hold, trade, and track. Plus, it is possible to narrow investments to a particular sector. Of course, investors need to do some research to help ensure that a particular company is both a good investment and commodity play.

Investors can also purchase options on stocks. Similar to options on futures contracts, options on stocks require a smaller investment than buying stocks directly. So, while your risk when investing in a stock option may be limited to the cost of the option, the price movement of a commodity may not directly mirror the price movement of the stock of a company with a related investment.

An advantage of investing in stocks in order to enter the commodities market is that trading is easier because most investors already have a brokerage account. Public information about a company's financial situation is readily available for investors to access, and stocks are often highly liquid.

There are some relative disadvantages to investing in stocks as a way of gaining access to the commodities market. Stocks are never a pure play on commodity prices. In addition, the price of a stock may be influenced by company-related factors that have nothing to do with the value of the related commodity that the investor is trying to track.

Using ETFs and Notes to Invest in Commodities

Exchange-traded funds (ETFs) and exchange-traded notes (ETNs) are an additional option for investors who are interested in entering the commodities market. ETFs and ETNs trade like stocks and allow investors to potentially profit from fluctuations in commodity prices without investing directly in futures contracts.

Commodity ETFs usually track the price of a particular commodity–or group of commodities that comprise an index–by using futures contracts. Sometimes investors will back the ETF with the actual commodity held in storage. ETNs are unsecured debt securities designed to mimic the price fluctuation of a particular commodity or commodity index. ETNs are backed by the issuer. ETFs and ETNs allow investors to participate in the price fluctuation of a commodity or basket of commodities, but they typically do not require a special brokerage account. There are also no management or redemption fees with ETFs and ETNs because they trade like stocks. However, not all commodities have ETFs or ETNs that are associated with them.

BAL: iPath Bloomberg Cotton Subindex Total Return ETN; CAFE: iPath Pure Beta Coffee ETN; NIB: iPath Bloomberg Cocoa Subindex Total Return ETN

Another downside for investors is that a big move in the price of the commodity may not be reflected point-for-point by the underlying ETF or ETN. In addition, ETNs specifically have credit risk associated with them since they are backed by the issuer.

CORN: Teucrium Corn Fund; SOYB: Teucrium Soybean Fund; WEAT: Teucrium Wheat Fund

Using Mutual and Index Funds to Invest in Commodities

While you cannot use mutual funds to invest directly in commodities, mutual funds can be invested in stocks of companies involved in commodity-related industries, such as energy, agriculture, or mining. Like the stocks they invest in, the shares of the mutual fund may be impacted by factors other than the fluctuating prices of the commodity, including general stock market fluctuations and company-specific factors.

However, there are a small number of commodity index mutual funds that invest in futures contracts and commodity-linked derivative investments, and therefore provide investors with more direct exposure to commodity prices.

By investing in mutual funds, investors get the benefit of professional money management, added diversification, and liquidity. Unfortunately, sometimes management fees are high, and some of the funds may have sale charges.

Using Commodity Pools and Managed Futures to Invest in Commodities

A commodity pool operator (CPO) is a person (or limited partnership) that gathers money from investors and then combines it into one pool in order to invest that money in futures contracts and options. CPOs distribute periodic account statements, as well as annual financial reports. They are also required to keep strict records of all investors, transactions, and any additional pools they may be operating.

CPOs will usually employ a commodity trading advisor (CTA) to advise them on trading decisions for the pool. CTAs must be registered with the Commodity Futures Trading Commission (CFTC) and are usually required to get a background check before they can provide investment advice.

Investors may decide to participate in a CPO because they have the added benefit of receiving professional advice from a CTA. In addition, a pooled structure provides more money and more opportunities for the manager to invest. If investors choose a closed fund, all investors will be required to contribute the same amount of money.

The Bottom Line

Both novice and experienced traders have a variety of different options for investing in financial instruments that give them access to the commodity markets. While commodity futures contracts provide the most direct way to participate in the price movements of the industry, there are additional types of investments with less risk that also provide sufficient opportunities for commodities exposure.

In the most basic sense, commodities are known to be risky investment propositions because they can be affected by uncertainties that are difficult, if not impossible, to predict, such as unusual weather patterns, epidemics, and disasters both natural and man-made.