What are Commodities and How Are They Traded?

Commodities

Let’s say you’re at a cocktail party and a friend says that you should diversify your common stock portfolio by investing in commodities. You consider yourself a smart investor and think, why not? But, what are commodities and how are they different from your current investments?

So, what is commodities investing?

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Commodities investing differs from stocks in a couple of important ways. The first way is that they are real, tangible things that you can hold on to. You can actually take physical delivery of a commodity. And, historically, that was the whole point.

Stocks are less tangible. They represent an interest in a business, which isn’t something you could ever possibly have delivered to your home or office. Sure, stock certificates are printed on pretty parchment paper that can be delivered to you. But having a truck back up and drop an entire public company onto your driveway just ain’t gonna happen.

The second way that commodities differ from stocks is that they have a finite life. Part of this is the natural state of most commodities, which are consumable. So, once you eat ‘em they’re gone. By comparison, a business is a going concern, and for the most part, a perpetuity.

The origins of commodities trading

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Commodities include things that grow in or above the ground. Think of corn and cows.  Also included are things that get dug out of the ground, like gold and silver. There are processed or refined commodities such as crude oil and natural gas. Just about every natural resource that we use on a regular basis is traded as a commodity.

Commodities trading in America dates back to the 19th century when farmers would bring their crops to market and sell them right then and there (on the spot) to merchants looking to distribute them around the country.

Oh, by the way, this is where the term “spot price” comes from. That’s the price you can pay right now to take delivery of a commodity. Eventually, farmers and merchants got to the point where they would agree on a price for crops that would be delivered at some future date. This ultimately evolved into what are today referred to as “futures contracts”.

Those contracts provided both the buyer (the merchant) and the seller (the farmer) with options (no pun intended). If the merchant decided that he didn’t want to take delivery of the farmer’s crop, he could sell the contract to someone that did. Likewise, if the farmer decided to hop on a jet to Hawaii, he could sell the contract to another farmer that would deliver his crop instead. (IMPORTANT NOTE: Neither airplanes nor the State of Hawaii existed at the time…but it creates nice imagery, don’t you think?)

In time, these contracts started getting traded by folks other than farmers and merchants. Enter Louis Winthorpe, III and Billy Ray Valentine!

Speculators entered the market to buy and sell the contracts expecting to profit from changes in their value. And, for the most part, that’s what you’d be doing if you decided to start trading commodities. That is unless you’re a farmer with a million bushels of wheat you need to hedge.

But before you run out and open a commodities trading brokerage account, you’ve got to consider the risks; the biggest of which is that these investments are leveraged! Here’s an example.

Commodities trading in action

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Let’s look at wheat. Right now, September 2016 wheat futures trade in the $4.20 range. Contracts are based on delivering 5,000 bushels of grain (about 136 metric tons). That’s a lot of bread! This makes one contract worth roughly $21,000 ($4.20 x 5,000). Again, a lot of bread. But the initial margin requirement (earnest money) to buy that contract is somewhere in the neighborhood of 10%, or about $2,100. If wheat prices rise by 10%, the contract’s value goes to $23,000 and your profit is $2,000 ($23,000 – $21,000).  You’ve nearly doubled your investment. Yippee! But, what happens if wheat prices decline by 10%?

In this case the futures contract trades at just $3.78, the contract’s value slips to $18,900, and your $2,100 loss completely wipes out your account! So, while there is no question that commodity futures trading can be wicked profitable, it is so because it is also inherently risky.

So, if you’re dead set on adding this asset class to your otherwise plain-vanilla portfolio, perhaps a safer approach would be to use Commodity ETFs (Exchange Traded Funds). ETFs may not make for exciting cocktail party banter, but they’ll allow you to at least be able to pay for your drinks.

If you’d like to further educate yourself on commodities than take our Big Money Investing course to deeper your understandings.

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One response to “What are Commodities and How Are They Traded?”

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