Key Takeaways
- Commodities, one of the major investment classes, are raw materials or agricultural products that can be bought and sold in bulk.
- Commodities are traded on a futures market, in which suppliers and buyers of commodities bargain for payment of the goods to be delivered on a future date.
- On the delivery date, the commodity is traded at the price in the contract, no matter what the current price for that good is.
- Businesses from packaged food companies to airlines rely on commodities.
- Commodities often are not a good choice for individual or new investors.
Definition and Example of a Commodity
Commodities are raw materials or agricultural products that can be bought and sold. They are produced in large quantities, which means they are usually traded in bulk. Along with stocks, bonds, and real estate, commodities are one of the major asset classes.
In general, commodities are not good choices for individual investors, due to their bulk nature. Many businesses, though, rely on them. They are vital for many industries from packaged food to airlines.
A commodity can be a natural resource or agricultural product. Some kinds are:
- Wheat, corn, soybeans, or other bulk foods
- Cattle or other livestock
- Cotton
- Lumber
- Sugar
- Precious metals, such as gold
- Domestic and foreign currencies
- Coal, oil, and other fossil fuels
Commodities are used to produce other goods and services. They are sold by the companies that produce them, and bought by companies that use them. For example, lumber is used to produce things like buildings and furniture.
Commodities of the same grade are described as “fungible,” which means they can be swapped with each other, no matter who produced, mined, or farmed them.
For example, if high-quality copper is produced from two mines, one in Colorado and one in Wyoming, it is fungible. To a buyer, it doesn’t matter which mine produced it. What matters is that the same quality and purity of copper can be received.
How Commodities Work
Commodities are traded on a futures market, where the people who produce goods and the people who buy them bargain for payment. These contracts also set a future date on which the goods will be delivered. People who trade in commodities can be:
- Farmers and miners who produce goods
- Businesses that buy or use goods
- Investors and speculators
- Consumers and strategic users
There are many examples of commodity trades.
- Farmers pre-sell corn in the futures market. They won’t lose money if corn prices decline between planting and when they’re ready to send the corn to market.
- An airline buys fuel at a fixed rate using a futures contract, allowing it to avoid surprise changes in the prices of crude oil and gasoline.
- A chain of coffee shops buys huge amounts of raw coffee on the futures market to make its branded coffee. The purchase is made at today’s prices, so the cost of making the branded coffee will be stable.
Most commodities, but not all, trade on what is known as a “commodities exchange.” Two common ones are the Chicago Board of Trade (CBT) and the New York Mercantile Exchange (NYMEX). These exchanges allow commodities to be bought and sold in the same way that stocks are. They create a standard contract for when a trade will happen, which creates a fixed price and future delivery date for the good that is being traded. On that date, the commodity is traded, and money exchanges hands. The price at that time is the one in the contract, no matter what the current price of the commodity on the open market is.
What It Means for Individual Investors
Commodities are most likely not a good option for you if you are a new or individual investor.
When you trade commodities, you are paying for the right or obligation to buy or sell the underlying future, which itself is a right or obligation to buy or sell the underlying asset without collecting it. That can be confusing and risky for new buyers who don’t have the background to know how prices and goods may move in the future. The funds that you need to buy and sell commodities in bulk may also be out of reach.
Individual commodities buyers often trade in items like precious metals. For example, a buyer might purchase large amounts of gold coins. Then, the buyer would store them in a safe place as a hedge against inflation risk.
Individual investors can also invest in commodities pools, which are a way to diversify the assets you hold. These pools are often structured as mutual funds or exchange-traded products (ETPs), but they are different from traditional mutual funds or exchange-traded funds. You do not own a share of the assets themselves. Instead, you are buying the right to buy or sell an asset for a short window of time in the future. That can be very risky.
note
The government body in charge of regulating these trades, the Commodity Futures Trading Commission (CFTC), cautions that investors should be wary of high-yield investment opportunities in futures, including foreign exchange (forex) options, in order to avoid fraud.
More experienced investors know both the futures market and the needs of companies that use a given good. As a result, they may have more success trading these assets despite the risks involved.
Alternatives to Commodities
There are many asset classes you can invest in besides commodities. These include:
There are stocks, mutual funds, or exchange-traded funds that work with specific products or goods. You can get exposure to commodities by investing in these assets. Rather than investing in a commodity directly, you could invest in:
- A mutual fund that includes that commodity
- Shares of a company that farms or mines that good
Taking these approaches can be less risky for the average investor.