Definition and Example of a Commodity
How Commodities Work
What This Means for Individual Investors
Alternatives to Commodities
Definition and Example of a Commodity
A commodity is a natural resource or agricultural product that is traded in bulk. When traded, commodities are considered one of the main asset classes for investors. Commodities are raw materials or agricultural products that can be bought and sold in large quantities. Alongside stocks, bonds, and real estate, commodities are one of the main asset classes.
In general, commodities are not a good option for individual investors due to their bulk nature. However, many businesses rely on them. They are essential for many industries from packaged foods to airlines.
A commodity can be a natural resource or an agricultural product. Some types include:
- Wheat, corn, soybeans, or other bulk food products
- Cattle or other livestock
- Cotton
- Wood
- Sugar
- Precious metals like gold
- Local and foreign currencies
- Coal, oil, and other fossil fuels
Commodities are used to produce other goods and services. They are sold by companies that produce them and are bought by companies that use them. For example, wood is used to produce things like buildings and furniture.
Commodities of the same grade are described as “interchangeable,” meaning they can be substituted for one another regardless of the company that produced, extracted, or farmed them.
For example, if high-quality copper is produced from two mines, one in Colorado and the other in Wyoming, they can be substituted for one another. For the 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 in the futures market, where suppliers and buyers negotiate a set price for the commodities to be delivered at a future date. On the delivery date, the commodity is traded at the price specified in the contract, regardless of the current price of that commodity in the open market.
People who trade commodities may include:
- Farmers and miners who produce commodities
- Companies that buy or use commodities
- Investors and speculators
- Consumers and strategic users
There are many examples of commodity trading. For example:
- Farmers sell corn futures in the futures market. They won’t lose money if corn prices drop between planting and when they are ready to send the corn to market.
- An airline buys fuel at a fixed price using a futures contract, allowing it to avoid sudden changes in crude oil and gasoline prices.
- A coffee chain buys large quantities of raw coffee in the futures market to create its signature coffee. The purchase is made at today’s prices, so the cost of making the signature coffee will remain stable.
Most commodities, but not all, are traded on what is known as the “Commodity Exchange.” Two common exchanges are the Chicago Board of Trade (CBT) and the New York Mercantile Exchange (NYMEX). These exchanges allow buying and selling commodities in the same way as stocks. They create a standard contract for the transaction, which establishes a fixed price and a future delivery date for the traded commodity. On that date, the commodity is traded, and money is exchanged. The price at that time is the price in the contract, regardless of the current price of the commodity in the open market.
What This Means for Individual Investors
It’s likely that commodities are 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 in turn is the right or obligation to buy or sell the underlying asset without taking possession of it. This can be confusing and risky for new buyers who do not have the background to understand how prices and commodities move in the future. The funds you need to buy and sell commodities in bulk may also be out of reach.
Buyers
Individual commodities often trade in items such as precious metals. For example, a buyer may purchase large quantities of gold coins. The buyer then stores them in a safe place as protection against inflation risks.
Individual investors can also invest in a commodity pool, which is a way to diversify the assets they own. These pools are often organized as mutual funds or exchange-traded products (ETPs), but they differ from traditional mutual funds or exchange-traded funds. You do not own a share in the assets themselves. Instead, you are buying the right to buy or sell an asset for a short period of time in the future. This can be very risky.
The government agency responsible for regulating these trades, the Commodity Futures Trading Commission (CFTC), warns investors about the need to be cautious regarding high-yield investment opportunities in futures contracts, including foreign exchange (forex) options, to avoid fraud.
Experienced investors understand the futures market and the needs of businesses that use a particular commodity. As a result, they may have more success trading these assets despite the mentioned risks.
Alternatives to Commodities
There are many asset classes you can invest in besides commodities. These include:
- Stocks
- Bonds
- Mutual funds
- Exchange-traded funds (ETFs)
- Real estate
- Real estate investment trusts (REITs)
There are stocks or mutual funds or exchange-traded funds that work with specific products or commodities. You can gain exposure to commodities by investing in these assets. Instead of investing in a commodity directly, you can invest in:
- A mutual fund that includes that commodity
- Shares of a company that grows or mines that commodity
These methods can be less risky for the average investor.
Source: https://www.thebalancemoney.com/what-are-commodities-356089
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