Dealing commodities is an old profession, dating back further than trading stocks and bonds. Ancient civilisations traded a wide array of commodities, from seashells to spices, and commodity trading was an essential business, through the building of empires. The might of empires could be viewed as proportionate to their ability to create and manage complex trading systems and facilitate commodity exchange. This served as the wheels of commerce, economic development and taxation for a kingdom's treasures.
A commodity is a basic good, used in commerce, that is interchangeable with other commodities of the same type. They are most often used as inputs in the production of other goods and services. The quality of a given commodity may differ slightly, but it is essentially uniform across all producers. When traded on an exchange, commodities must also meet specified minimum standards, also known as a basis grade. The basic idea is that there is little differentiation between the same commodities from differing producers. A barrel of oil is basically the same product, regardless of the producer. By contrast for example, for electronic merchandise, the quality and features may be completely different. Some traditional examples of commodities include grains, gold, beef, oil and natural gas. More recently, the term has expanded to include financial products, such as foreigh currencies and indexes. Technological advances have also led to new types of commodities being exchanged, for example mobile phone minutes and bandwidth.
The sale and purchase of commodities are usually carried out through futures contracts on exchanges that standardise the quantity and minimum quality of the commodity being traded. There are 2 types of traders that trade commodity futures. The first are buyers and producers of commodities that use the futures contracts for the hedging purposes for which they were originally intended. These traders actually make or take delivery of the physical commodity when the futures contract expires. For example, a wheat farmer that plants a crop can hedge against the risk of losing money if the price of wheat falls before the crop is harvested. The farmer can sell wheat futures contracts when the crop is planted and guarantee a predetermined price for the wheat at harvest time.
The second type of commodities trader is the speculator. These are traders who trade in the commodities markets for the sole purpose of profiting from the volatile price movements. Speculators never intend to make or take delivery of the physical commodity when the futures contract expires. Many of the futures markets are very liquid and have a high degree of daily range and volatility, making them tempting and ideal markets for intraday traders. Many of the index futures are used by brokerages and portfolio managers to offset risk. Also, since commodities do not typically trade in tandem with the equity and bond markets, some commodities can also be used effectively to diversify an investment portfolio.
There are still many commodities exchanges worldwide, although many have merged or gone out of business over the years. Most carry a few different commodities, though some specialise in a single group, such as the London Metal Exchange. In the US, the most popular exchanges include those run by the CME Group, such as the New York Mercantile Exchange. The CFTC regulates commodity futures and options markets in the US. Their main objective is to promote competitive, efficient and transparent markets that help to protect consumers from fraud, manipulation and unscrupulous practices. Regulation of commodity markets have continued to remain in the spotlight after 4 leading investment banks were caught up in a precious metals manipulation probe in 2014.
The basic economic principles of supply and demand typically drive the commodities markets. Lower supply drives up demand which equals higher prices, and vice versa. Major disruptions in supply, such as a widespread health scare among cattle, might lead to a spike in the generally stable and predictable demand for livestock. On the demand side, global economic development and technological advances often have a less dramatic, but important effect on prices. For example, the emergence of China and India as significant manufacturing players has contributed to the declining availability of industrial metals, such as steel, for the rest of the world.
Commodities are split into 2 types, which in themselves split into 4 categories. The 2 types are hard and soft commodities. Hard commodities are typically natural resources that must be mined or extracted, for example gold, rubber and oil. Soft commodities are agricultural products or livestock, such as wheat, coffee, pork and sugar. The 4 categories that commodities fall into today are metals, energy, livestock and meat, and agricultural.
Volatile or bearish stock markets typically find scared investors scrambling to transfer money to precious metals such as gold, which has historically been viewed as a reliable, dependable metal with conveyable value. Precious metals can also be used as a hedge against high inflation or currency devaluation. Energy plays are also common for commodities. Global economic developments and reduced oil outputs from wells around the world can lead to upward surges in oil prices, as investors weigh and assess limited oil supplies with ever increasing energy demands. Economic downturns, production changes from OPEC, and emerging technological advances such as wind, solar and biofuel, that aim to compliment oil as an energy source, should also be considered.
Grains and other agricultural products have a very active trading market. They can be extremely volatile during summer months or periods of weather transitions. Population growth, combined with a limited agricultural supply, can provide opportunities to ride agricultural price increases.
Trading futures carries with it several disadvantages and advantages. On the negative side, they can be very volatile markets and direct investment can be very risky, especially for inexperienced investors. The use of leverage will magnify both losses and gains. Also, a trade could go against you very quickly and you could lose your initial deposit and more before you are able to close the position. However you should be trading within your limits anyway. The advantages include the fact that it is a pure play on the underlying commodity. Small deposit accounts also can control full size contracts that the average person would not be able to afford. Finally, unlike some instruments, you can go long or short very easily.
Aside from the use of futures, there are numerous ways that commodities can be traded. These include commodity ETFs, mutual funds and index funds, or through a commodity pool operator. More commonly though, instead of futures, investors will trade commodities in the form of stocks. Many investors use stocks of companies and industries related to a commodity in some way. For example, those interested in oil could invest in drillers, refineries, tanker companies or diversified oil companies. Those interested in gold could purchase mining companies, smelters, refineries, or any business that deals with bullion.
Equities are said to be less prone to volatile swings than futures. Also, stocks are very easy to buy, hold, track and trade, and it is possible to narrow investments to a particular sector. Of corse, investors need to do their research to help ensure that a particular company is both a good investment and commodity play. Most futures contracts will also have options associated with them. Buying options on futures contracts is similar to putting a deposit on something, rather than buying it outright. You have the right, but not the obligation, to follow through on the transaction. Therefore, if the price of the contract fails to move in the direction you anticipated, you have limited your loss to the cost of the option.
There are a variety of commodity investments for novice and experienced traders to consider. Although futures provide the most direct way to participate, other investment types with varying risk provide sufficient opportunities. Commodities can quickly become risky as they can be affected by uncertainties that are difficult, if not impossible, to predict. These would include unusual weather patterns, epidemics and disasters, both natural and man made.