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What are commodities?
Commodities are raw materials or agricultural products that are often used to produce finished goods. Many different types of commodities exist today, but broadly they can be broken down into three distinct categories:
Energy. Commodities in the energy sector include crude oil, natural gas, coal and other fossil fuels.
Metals. Some of the more popular metals are gold, silver, platinum and other precious metals. There is also a market for industrial metals such as copper, iron ore, aluminum, etc.
Agricultural. These commodities include staple crops, such as wheat, sugar, corn and cotton. In addition, livestock like cattle or hogs are also considered an agricultural commodity.
The basics of commodity investing
Trading commodities is unique because consumers can physically purchase and own a commodity, whereas owning a stock or a bond is a contractual agreement between consumers and the issuing company.
Commodities generally do not have a discernible difference in quality from one producer to another, making them unique from other goods available for purchase. In other words, wheat is wheat, oil is oil, and a cow is a cow regardless of where it was purchased.
Commodity prices can be highly volatile, but historically speaking, they have a low correlation to the stock market. As a result, exposure to commodities can help reduce volatility as part of a well-diversified portfolio.
There are many different ways to trade commodities. Whether you’re trading futures contracts, company stock, or purchasing a physical commodity, each has advantages and disadvantages.
» MORE: What are alternative assets?
How are commodity prices determined?
Commodity prices are primarily driven by supply and demand for each specific product. Price movements for individual commodities often have a low correlation with the larger financial market. If the market drops, commodity prices may be unaffected (or even move in the opposite direction). Due to this low or negative correlation with the stock market, many investors view commodities as an alternative way to hedge against a market dip.
Instead, commodity price movement often coincides with increasing or decreasing inflation. When inflation is rising, commodity prices typically go up as the cost of raw materials increases. As a result, many investors view commodities as a way to hedge against increasing inflation.
Are commodities a safe investment?
While commodities can help add diversity to a well-balanced portfolio, they can also be extremely volatile. Commodity prices can be greatly impacted by interruptions in supply and demand due to unforeseen circumstances, making their price movements incredibly difficult to predict. For example, as automobile and air traffic were greatly reduced during the COVID-19 pandemic, demand for oil and gas fell sharply and prices plummeted.
How to invest in commodities
For investors interested in gaining some exposure to the commodity market, there are a few different ways to do so:
A futures contract represents an agreement to buy or sell a set amount of product at a future date for a predetermined price. Once the contract expires, the buyer and seller are obligated to complete the transaction at the predetermined price.
Trading futures involves a lot of speculation about price movement, and investors in this space often take out margin loans to finance their futures trading. Because commodity prices are so dependent on supply and demand, there can be a high level of volatility — meaning that futures contracts come with a high level of risk.
Purchasing physical commodities
Whereas futures traders don’t ever physically acquire thousands of barrels of crude oil or a truckload of cows, buying physical commodities such as gold or silver allows you to possess the good you own physically. The physical commodities purchased by investors typically are precious metals. Still, it’s important to note that precious metals usually have higher transaction costs than other investments.
Instead of purchasing futures contracts or bars of gold, another way to gain exposure to commodities is by purchasing stock in the companies that produce these products. For example, an oil drilling company or a mining company focused on precious metals can help you gain exposure to the commodities market. The stock performance of these companies is often very dependent on the price of the commodity they produce.
Mutual funds, ETFs and ETNs
If you’re thinking about adding commodities to your investment portfolio, it can be expensive to do so while maintaining an appropriate level of diversification. A cheaper option is to purchase mutual funds, exchange-traded funds or exchange-traded notes focused on a specific commodity. These funds have relatively low minimums to get started, and they pool funds from many investors to buy multiple commodity stocks or futures contracts.
For instance, an energy ETF might invest in many different futures contracts to track oil prices while also investing in stock for companies that produce oil for consumers. This allows you to add exposure to various futures contracts and company stocks for a low cost. Depending on what you buy, some funds may have internal management fees.
» Learn more: What are the best commodity ETFs?