What are Commodities?

Commodities are physical assets such as agricultural, mining, or energy products that can be bought and sold. These interchangeable goods are traded daily in the commodities market. Commodities usually fall into three categories: metals, energy, and agriculture. 

Metals Commodities – These include precious metals such as gold, silver, and platinum, or non-precious metals such as copper, iron, and steel.

Energy Commodities – These include energy resources such as crude oil, natural gas, gasoline, and electricity.

Agriculture Commodities – These include items that hail from the agricultural sector such as corn, sugar, wheat, coffee, and cotton. Additionally, items such as cattle and even pork bellies are classified as agricultural commodities.

Commodities are grouped into either “hard” or “soft”. Hard commodities denote anything that was mined or drilled such as gold, crude oil, or natural gas. Soft commodities are classified as anything that was grown or raised such as cattle, coffee, or corn.

Investing in commodities can be accomplished through such things as commodity futures, options on commodity futures, and commodity ETFs. Additionally, investors can gain exposure to this asset by purchasing stocks in companies that produce commodities in some capacity.

How to Trade Commodities With Futures

In the United States, there are commodities exchanges located in New York (New York Mercantile Exchange), Chicago (Chicago Mercantile Exchange), and Atlanta, Georgia (the Intercontinental Exchange). 

The most popular way to trade and invest in commodities is via commodity futures. Commodity futures are a financial contract between parties to buy or sell a commodity at a specific price on a predetermined date in the future. These standardized derivative agreements are traded on futures exchanges, such as the Chicago Mercantile Exchange, or the New York Mercantile Exchange. A principle use of commodity futures contracts is to hedge against potential volatility in the commodities market. Additionally, futures can be used to speculate on the price movement of a commodity.

With commodity futures, the specific price agreed upon to buy or sell an asset is deemed the “forward price”. The predetermined date in the future when payment and delivery transpire is referred to as the “delivery date”.

It is crucial to understand with commodity futures, that the parties who enter the contract are obligated to follow through with the particulars of the specific contract – either to buy or sell by the delivery date.

In order to trade commodity futures, you must first set up an account with a brokerage firm that offers futures trading.

However, it is crucial to understand that trading commodity futures is volatile, speculative, has the potential for significant financial loss, and is NOT appropriate for all investors.

How Commodity Futures Work

Here is an example of how commodity futures contracts work:

Company A produces cheese, and purchases milk from Company B which operates as a dairy farm. Company B sells the milk for $2 a gallon. Another dairy farm opens which increases the number of milk-producing cows, therefore increasing the supply of milk. Thus, the price of milk drops to $1 a gallon. Company A is enjoying profits because it now costs less to produce their cheese. However, Company B is obviously losing money because of the decreased price of milk. Suddenly, an illness affects the milk production of the majority of cows. The price of milk now increases to $4 a gallon. Consequently, Company A’s profit from cheese declines drastically. 

Obviously, companies want to hedge against this type of volatility, so they broker futures contracts with investors. The particulars of Company A’s dairy futures contract stipulate that if milk prices increase above $2, then the investor pays the difference, and the company pays the locked-in price of $2. Should milk prices decline, then the investor profits from the gains, and Company A still pays $2 for milk.

How to Trade Commodities With Options 

Another method of trading and investing in commodities is with options on commodity futures. An option is a derivative financial instrument that permits the holder to buy or sell (without any obligation) a commodity (or other assets like stocks, bonds, etc.) within a specific timeframe at a predetermined price. 

The predetermined price is referred to as the “strike price”. 

The specified timeframe is referred to as the “expiration date” of the option.

The cost of the option contract itself is called the “premium”.

Buying options on commodity futures is considered less risky, because you are not obligated to complete the particulars of the contract at the expiration date. Thus, should the price movement be contrary to your position, you only lose the premium on the specific futures option.

Commodity Trading With Stock

Investors can may also choose to gain exposure to commodities by purchasing shares in companies that produce commodities in some capacity. For instance, if you are interested in the gold sector, you could buy stock in a company that mines the precious metal.

It must be understood that because there is the potential for volatility in the stock market, stock trading in general is considered speculative and riskier than some other investment vehicles. Stock trading has the potential for significant financial loss and is NOT appropriate for all investors.

An alternative for some investors is purchasing stock options in companies that produce commodities in some capacity. Buying stock options comes with less risk, because you only invest capital in the premium of the option. 

Essentially, buying stocks to invest and trade in commodities gives you indirect access to the commodities market. Moreover, there is the potential for additional factors that will influence the price movement of a company’s share price, not merely the price movement of the specific commodity.

Commodity Trading With ETFs

Some investors may decide to gain exposure to commodities with commodity ETFs (exchange-traded funds). ETFs are advantageous because they can balance financial risk by investing in a specific physical commodity or a basket of commodities, or a basket of commodity futures. For instance, iShares Silver Trust (SLV) is the most widely-traded commodity ETF on the marketplace and has possession of physical silver bullion. 

Commodity ETF shares are traded throughout the business day on exchanges, akin to stocks. 

However, it is crucial to understand that the commodities market is highly volatile. Commodity trading is speculative, has the potential for significant financial loss, and is NOT appropriate for all investors.

Comparison Table On The Different Types Of Trading

Here is a comparison table examining the different types of trading.

Commodity Trading FAQs