Commodities: A General Overview and FAQs
Written By Ben Lewis
What are commodities, how are they defined in the context of investing?
A commodity is a raw natural resource in which the individual units are seen as equal in value.
This means that these resources are universally exchangeable and can be traded as equals.
Questions about producers of the materials and the quality of materials can be mitigated when trading commodities.
There are a variety of ways to invest in commodities that do not have to do with the physical purchase of the goods themself.
What are the different categories of commodities?
Commodities, in general, fall under one of the following sectors: energy, metals, agriculture, and livestock.
Some of the most prominent individual examples of a commodity include natural gas (energy), oil (energy), wheat (agriculture), corn (agriculture), soy (agriculture), canola (agriculture), pork (livestock), beef (livestock) , iron (metals), gold (metals), silver (metals), and copper (metals).
Why invest in commodities? What are potential benefits and risks?
Benefits:
Investing in commodities can provide investors with diversification of their portfolio and can give them exposure to markets which often influence the trading of securities. Often commodity investing can give investors the possibility of large gains without having the need to front large sums of money. This is typically due to margin accounts which are often backed by brokers. Additionally, commodities can often serve as a hedge against inflation. When the value of stocks and bonds deplete, commodities often increase in price and remain strong.
Risks:
Some forms of commodity investing are not user friendly because it often involves the purchase of physical assets as well as contracts where the resources bought must be managed by the buyer. Additionally, some online accounts where commodities can be traded involve margin accounts in which investors use borrowed money to hold a larger position. These types of accounts often include high interest rates and can cause investors to make rash decisions at the prospect of making large sums of money, even though they may be at risk of losing a lot of money and going into significant debt. Overall, commodities can be extremely volatile and some forms of commodity trading is more of a gamble than a safe investment.
What are the primary ways to invest in commodities?
Physical Ownership
Typically, physical ownership of commodities primarily applies to precious metals such as gold and silver. These metals are forged into bars which can be purchased as a financial investment.
Downsides of owning physical commodities include issues with storage, insurance, and liquidity.
Physical ownership is not a very user friendly option for new commodities investors.
Futures contracts
Futures contracts are agreements in which the buyer or seller agrees to buy an amount of a commodity for a specified price at a specific date.
Investors in futures contracts typically use leveraged margin accounts which allow them to take a larger position in their investment, but at an increased risk of a higher loss.
The maintenance margins of an account are dependent upon the value of the contract being traded. A maintenance margin means an investor must maintain a certain ratio of investment compared to the amount of borrowed money that they are leveraging for their investment.
ETFs and Mutual Funds
These funds can include specific commodities or a variety of commodities within one fund to support a diversified portfolio.
The mechanism of funds investment is not uniform and depends on what is outlined by the fund. The fund may be based on futures contracts, options on futures, companies in the commodity sector, physical purchase of commodities, or a combination of the methods of investing.
It is important for investors to read fund disclosure statements before investing in order to understand exactly what and how the fund invests and to make sure investing goals are being matched with the purchase.
This is a user friendly method of investing in commodities as these funds can be passively or actively managed.
Stocks of Commodity related companies
Through basic brokerage accounts users can access companies which specifically produce or distribute commodities.
Investors who are looking to get exposure to a certain commodity through a company should look to gain some industry specific knowledge before investing. It is important to be able to distinguish between small and large extraction companies and how feasibility studies surrounding them may impact their share prices.
