Because commodities are raw materials — e.g. grain, oil, precious metals — the price of commodities fluctuates constantly owing to changes in supply and demand, which are in turn influenced by climate and weather patterns, workforce issues, global economic trends, and more.
While this can make it risky to invest in commodities, the volatility of this market also creates opportunities for traders, who try to take advantage of price swings.
In addition, although commodities can be traded on the spot market, they’re often bought and sold via derivatives like futures and options contracts, which can add to the higher risk level of this market.
Commodities are basic materials like agricultural products (meat, grains); energy sources (coal, oil, natural gas); and precious metals (copper, gold, nickel), which can be traded between producers and buyers.
In other words, commodities are the raw materials from which countless products are made: e.g. corn is a key ingredient in consumer staples; nickel is required for many technology products.
Commodities are differentiated from other types of securities by the fact that they’re basically interchangeable. One stock is clearly quite different from another, and is valued differently based on the company, the product, the market, and so on. But one barrel of oil is essentially the same as any other barrel of oil.
In addition, there are certain minimum standards, or basis grades, that ensure a common level of quality for most commodities. Basis grades may change from year to year, but once in place, all traded commodities must meet them.
• Meat (e.g. pork, beef)
• Grains and other agricultural products, including: corn, wheat, rice, coffee, cocoa, cotton and sugar
Technological advances have arguably added other commodities, such as internet bandwidth and cell phone minutes. Foreign currencies, indexes, and other financial products are also sometimes considered commodities.
Who Invests in Commodities?
There are two types of commodities investors, generally speaking.
• Producers who sell the raw goods on the spot market of a commodity, and buyers who need it to produce or manufacture certain goods. These trades typically involve futures contracts for specific quantities of the commodity involved for an agreed-upon price (e.g. an airline buying 500,000 barrels of oil for $90 a barrel).
• Traders who buy and sell commodities contracts, or options on underlying commodities, but don’t take delivery of the actual raw material. They are simply trying to profit from the volatility in different commodities markets, adding to commodity risk.
💡 Quick Tip: When people talk about investment risk, they mean the risk of losing money. Some investments are higher risk, some are lower. Be sure to bear this in mind when investing online.
These are some of the reasons investors wonder whether investing in commodities is high risk.
Unlike other stock market assets, commodities are generally traded on futures markets. Futures are pre-arranged agreements between traders who promise to buy or sell a given commodity for a specific price at a specific time in the future — hence the name.
Futures offer both the buyer and seller the opportunity to earn money, if the conditions are right. If the overall value of a commodity rises, the buyer makes money because they get it at the agreed-upon price, which may be lower than market value.
If the value of the commodity falls, the seller makes money because they’re still selling the commodity at the agreed-upon price, which is likely higher than market value.
However, because commodity prices are so volatile, changing on a weekly, and sometimes even daily basis, futures trading is highly risky to both parties involved.
Example of Commodities Risk
In many cases one trading party is going to lose money on the deal — though the set price of futures does allow traders some level of guarantee as to how much the seller or producer stands to lose.
For instance, let’s say a farmer negotiates a futures contract to sell her harvest of wheat. The buyer agrees to buy a specified amount of wheat at a specific price point.
If the value of wheat rises by the time the farmer harvests the crop, the buyer will get a good deal since he’s paying the price they’d already agreed upon (which was set based on the value of the wheat at the time of the negotiation). The buyer can then turn around and sell the wheat at a higher price, earning a profit.
On the other hand, if the value of wheat has fallen by the time the farmer sets out to harvest her yield, she is spared financial devastation by the guaranteed price bottom. Rather than losing out on her profits entirely, she’ll earn whatever the agreed-upon price was.
Meanwhile, the buyer is on the losing end of the contract, and now has a quantity of wheat that is worth less than what they must pay for it, per the agreement.
Why Invest in Commodities?
Given the risk involved with investing in commodities, what motivates investors to trade them?
For one thing, investing in commodities gives investors the opportunity to diversify their portfolio with a whole new class of assets — one that generally performs in opposition to the stock market itself. (That is, when the stock market is bearish, commodities tend to increase in value.)
Furthermore, diversification can be a useful risk-management tactic, and investing in commodities may be a way to round out a portfolio based on more traditional investments like stocks and bonds.
Commodities do also have some characteristics that give them a unique advantage in the world of investments. Because they’re often traded via futures contracts, there’s a guaranteed sale price and date. For those willing to take on the risk of being on the losing end of the contract, the potential to gain a specified amount can be appealing.
Benefits of Investing in Commodities
Commodities can add diversification to a portfolio which can help with risk management. Since commodities have low correlation to the price movements of traditional asset classes like stocks and bonds they may be more insulated from the stock volatility that can affect those markets.
Supply and demand, not market conditions, drive commodities prices which can help make them resilient throughout a changing business cycle.
Trading commodities can also help investors hedge against rising inflation. Commodity prices and inflation move together. So if consumer prices are rising commodity prices follow suit. If you invest in commodities, that can help your returns keep pace with inflation so there’s less erosion of your purchasing power.
However, none of these benefits negates the risks involved with investing in or trading commodities.
💡 Quick Tip: Newbie investors may be tempted to buy into the market based on recent news headlines or other types of hype. That’s rarely a good idea. Making good choices shouldn’t stem from strong emotions, but a solid investment strategy.
Disadvantages of Investing in Commodities
The biggest downside associated with commodities trading is that changes in supply and demand can dramatically affect commodity pricing, which can directly impact your returns. Commodities that seem to go up and up in price can also come crashing down in a relatively short time.
There is also a risk inherent to commodities trading, which is the possibility of ending up with a delivery of the physical commodity itself if you don’t close out the position. You could then be on the hook to sell the commodity.
In addition, commodities don’t offer any benefits in terms of dividend or interest payments. While you could generate dividend income with stocks or interest income from bonds, your ability to make money with commodities is based solely on buying them low and selling high.
How to Invest in Commodities
If you’re interested in how to trade commodities, there are different strategies to consider.
Trading Commodities Stocks
If you’re already familiar with stock trading, purchasing shares of companies that have a commodities connection could be a relatively easy first step. Trading commodities stocks is the same as trading shares of any other stock. The difference is that you’re specifically targeting companies that are related to the commodities markets in some way. This requires understanding both the potential of the company, as well as the potential impact of fluctuations in the underlying commodity.
For example, if you’re interested in gaining exposure to agricultural commodities, you might buy shares in companies that belong to the biotech, pesticide, or consumer staples industries.
Or, you might consider purchasing energy stocks or mining stocks if you’re more interested in those commodities markets.
As you would with any other stock, you need to consider your portfolio’s current asset allocation, and whether adding certain commodity stocks to the equity portion is in line with your goals.
Recommended: What Is Asset Allocation?
Futures Trading in Commodities
As noted above, a futures contract represents an agreement to buy or sell a certain commodity at a specific price at a future date.
So, for example, an orange grower might sell a futures contract agreeing to sell a certain amount of their crop for a set price. A company that sells orange juice could then buy that contract to purchase those oranges for production at that price.
This type of futures trading involves the exchange of physical commodities or raw materials. For the everyday investor, futures trading in commodities typically doesn’t mean you plan to take delivery of two tons of coffee beans or 4,000 bushels of corn. Instead, you buy a futures contract with the intention of selling it before it expires.
Futures trading in commodities is speculative, as investors are making educated guesses about which way a commodity’s price will move at some point in the future.
Trading Commodities ETFs
Commodity ETFs (or exchange-traded funds) can simplify commodities trading. When you purchase a commodity ETF you’re buying a basket of securities, as you would when buying any type of ETF. These can target a picture type of commodities, such as metals or energy, or offer exposure to a broad cross-section of the commodities market.
A commodity ETF can offer basic diversification, though it’s important to understand what you own. For example, a commodities ETF that includes options or commodities futures contracts may carry a higher degree of risk compared to an ETF that includes commodities companies, such as oil and gas companies, or food producers.
Recommended: How to Trade ETFs
Investing in Mutual and Index Funds in Commodities
Mutual funds and index funds offer another entry point to commodities investing. So investing in a commodities mutual fund that’s focused on water or corn, for example, could give you exposure to different companies that build technologies or equipment related to water sustainability or corn production.
Even though these funds allow you to invest in a portfolio of different securities, remember that commodities mutual funds and index funds are still speculative, so it’s important to understand the risk profile of the fund’s underlying holdings.
A commodity pool is a private pool of money contributed by multiple investors for the purpose of speculating in futures trading, swaps, or options trading. A commodity pool operator (CPO) is the gatekeeper: The CPO is responsible for soliciting investors to join the pool and managing the money that’s invested.
Trading through a commodity pool could give you more purchasing power since multiple investors contribute funds. Investors share in both the profits and the losses, so your ability to make money this way can hinge on the skills and expertise of the CPO. For that reason, it’s important to do the appropriate due diligence.
Most CPOs should be registered with the National Futures Association (NFA). You can check a CPO’s registration status and background using the NFA website.
Stock Market Risks
While commodity risk is a factor when considering investing in commodity futures, it’s important to understand that all investments carry risk. For instance, stocks can gain and lose value as the companies that issue them perform well or poorly. It is always a possibility to lose all of the money put into a stock market investment in the case of a serious market decline or recession.
Of course, some market volatility is totally normal — and even healthy. And while nobody can predict the market perfectly, some tendencies can be seen over time.
For instance, while there’s no direct correlation between interest rates and stock market performance, in the past when interest rates go up, stock market performance tends to decline. That’s because companies, like individuals, can be priced out of taking loans they need for the continued growth and performance of their businesses, which may mean they have less money left over to reinvest or count as profit.
And during major global crises, like the recent outbreak of the novel coronavirus, markets can sometimes experience major turbulence and downturns.
The reality of risk is no reason to forego investing entirely, as investing is still one of the most powerful ways to grow wealth.
Managing Commodity Risk Through Diversification
Diversification means maintaining a variety of different asset types and classes — e.g. stocks, bonds, commodities, and other securities — and also ensuring that the investments within a given class come from different companies and industries.
That way if (and when) market volatility comes calling, investors will have their eggs in a variety of baskets, which may help mitigate the risk of steep losses if a single sector becomes too volatile.
Keeping a diverse portfolio can mean investing in stocks from a wide range of different companies with different attributes.
For instance, investors might choose small-cap, mid-cap, or large-cap stocks, which define companies based on the overall value of their market capitalization (the total cash value of outstanding stock the company has on the market). Investors may also choose to invest in companies from different industries, such as technology, renewable energy, communication or healthcare.
Along with including a multiplicity of company and stock types, investors can also pad out their portfolios with additional asset types, like government bonds or — you guessed it — commodities.
Because these assets sometimes perform in opposition to the market, they can be a good way to balance stock investments.
One easy way to get a lot of diversification with a relatively small amount of effort is to invest in ETFs and mutual funds.
Diversifying With ETFs and Mutual Funds
ETFs and mutual funds are slightly different, but operate in largely the same way: they’re baskets of assets, like stocks and bonds, that allow the investor to purchase a small piece of a wide swath of the market with a single buy.
ETFs, or exchange-traded funds, can be bought and sold just like shares of stock, and may track a well-known existing index like the S&P 500. ETFs can contain a range of different asset types, including commodities as well as stocks and bonds, and generally offer low expense ratios, since they may not be actively managed and don’t require as many trade or brokerage fees.
Mutual funds are similar to ETFs in their diversity of assets, but unlike ETFs, mutual funds are only bought and sold once per day, at the end of trading. Mutual funds are also often actively managed by a third party, which may offer some comfort to investors, but does tend to carry a higher expense ratio than would be found on a similar ETF.
Commodities trading is a high-risk strategy that may work better for investors who have a greater comfort with risk, versus those who are more conservative. Thinking through your risk tolerance, risk capacity, and timeline for investing can help you decide whether it makes sense to invest in commodities.
Fortunately, there are a number of ways to invest in commodities, including futures and options (which are a bit more complex), as well as stocks, ETFs, mutual and index funds — securities that may be more familiar.
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