Posted on August 26, 2022.

Commodities like iron ore, crude oil, and precious metals are the raw materials that power the global economy. They offer unique opportunities for smart investors to profit from their ever-changing prices, but investing in commodities requires specialized knowledge. It may carry more risk than conventional assets like stocks and bonds.

What are Commodities?

Commodities are raw materials that are used to produce finished goods, including agricultural products, mineral ores and fossil fuels. In terms of financial markets, commodities are physical goods that are bought, sold and traded in markets, distinct from securities such as stocks and bonds that exist only as financial contracts.

There are four main types of commodities:

Energy. The energy market includes oil, natural gas, coal and ethanol—even uranium. Energy also includes forms of renewable energy, like wind power and solar power.
Metals. Commodity metals include precious metals, like gold, silver, palladium and platinum, as well as industrial metals, like iron ore, tin, copper, aluminum and zinc.
Agricultural products. Agriculture covers edible goods, such as cocoa, grain, sugar and wheat, as well as nonedible products, such as cotton, palm oil and rubber.
Livestock. Livestock includes all live animals, such as cattle and hogs.

The prices of commodities shift constantly as patterns of supply and demand change throughout the world economy. War in Ukraine could lead to higher grain prices while climbing oil production in the Middle East could depress the global price of oil.

Investors in the commodity market aim to profit from supply and demand trends or reduce risk through diversification by adding different asset classes to their portfolios.

“The real advantages to commodity trading are differentiated exposures from the stock market and the potential for inflation protection,” says Ryan Giannotto, chartered financial analyst (CFA) and director of research at GraniteShares, an ETF issuer based in New York City.

What Is Commodity Trading?

Commodity trading is the exchange of different assets, typically futures contracts, that are based on the price of an underlying physical commodity. With the buying or selling of these futures contracts, investors make bets on the expected future value of a given commodity. If they think the price of a commodity will go up, they buy certain futures—or go long—and if they think price the commodity will fall, they sell off other futures—or go short.

Given the importance of commodities in daily life, commodity trading began long before modern financial markets evolved as ancient empires developed trade routes for exchanging their goods.

“Commodities trading is properly the birth of modern investing—the ceiling of the New York Stock Exchange is adorned with gold tobacco leaves in homage to the commodity trading that gave birth to the institution,” says Giannotto.

Modern commodity trading in the United States started in 1848 at the Chicago Board of Trade. It allowed farmers to lock in sales prices for their grain at different points during the year rather than only at harvest, when prices tended to be low. By agreeing to a price ahead of time through futures contracts, both the farmer and the buyer gained protection against price changes.

Today, the commodities market is much more sophisticated. Not only is there a long list of varied commodities being traded, but it’s also an international market with exchanges around the world. You can trade commodities nearly 24 hours a day during the workweek.

How to Trade Commodities

There are a few different ways to trade commodities in your portfolio, with their own advantages and disadvantages.

Commodities Futures

The most common way to trade commodities is to buy and sell contracts on a futures exchange. The way this works is you enter into an agreement with another investor based on the future price of a commodity.

For example, you might agree to a commodity future contract to buy 10,000 barrels of oil at $45 a barrel in 30 days. At the end of the contract, you don’t transfer the physical goods, but you close out your contract by taking an opposite position through the spot trading market. So in this example, when the futures contract reaches its expiration date, you would close out the position by entering another contract to sell 10,000 barrels of oil at the current market price.

If the spot price ends up higher than your contract’s price of $45 a barrel, you would make a profit, and if it’s lower, you would lose money. On the other hand, if you had entered a futures contract to sell oil, you would make money when the spot price goes down, and you would lose money when the spot price goes up. At any point, you could close out your position before the contract expiration date.

To invest in futures trading, you need to set up an account with a specialty brokerage account that offers these types of trades.

“Traders can access these markets by having an account with a brokerage firm that offers futures and options,” says Craig Turner, senior commodities broker with Daniels Trading in Chicago. You will owe a commodity futures trading commission each time you open or close a position.

Physical Commodity Purchases

When you trade futures contracts, you’re not buying or selling the physical commodity itself. Futures traders don’t actually take delivery of millions of barrels of oil or herds of live cattle—futures are all about betting on price changes only. However, for precious metals like gold and silver, individual investors can and do take possession of the physical goods themselves, like gold bars, coins or jewelry.

These investments give you exposure to commodity gold, silver and other precious metals and let you feel the actual weight of your investments. But with precious metals, transaction costs are higher than other investments.

“This strategy is only practical for value-dense commodities, such as gold, silver or platinum. Even then, investors will pay high markups over spot price on the retail market,” says Giannotto.

Commodities Stocks

Another option is to buy the stock of a company involved with a commodity. For oil, you could buy the stock of an oil refining or drilling company; for grain, you could buy into a large agriculture business or one that sells seeds.

These sorts of stock investments follow the price of the underlying commodity. If oil prices go up, an oil company should be more profitable so its share price would go up, too.

Investing in commodity stocks has less risk than investing directly in commodities because you aren’t just betting on the commodity price. A well-run company could still make money even if the commodity itself falls in value. But this goes both ways. While higher oil prices could help an oil company’s stock price, there are other factors as well, like their company management and total market share. If you are looking for an investment that perfectly tracks a commodity price, buying stocks is not an exact match.

Commodities ETFs, Mutual Funds and ETNs

There are also mutual funds, exchange traded funds (ETFs) and exchange traded notes (ETNs) that are based on commodities. These funds combine the money from many small investors to build a large portfolio that tries to track the price of a commodity or a basket of commodities—for example, an energy mutual fund based on multiple energy commodities. The fund may buy futures contracts to track the price, or it might invest in the stock of different companies with commodity exposure.

“Commodity ETFs truly democratized the commodities trading game to all investors—they are low cost, readily accessible and highly liquid,” says Giannotto.

With a small investment, you can gain access to a much larger range of commodities than if you tried to build the portfolio yourself. Plus, you’ll have a professional investor managing the portfolio. However, you’ll need to pay an additional management fee to the commodity fund over what it might cost if you had made the investments yourself. In addition, depending on the fund’s approach, it may not perfectly track the commodity price.

Commodity Pools and Managed Futures

Commodity pools and managed futures are private funds that can invest in commodities. They are like mutual funds except many of them are not publicly traded, so you need to be approved to buy into the fund.

These funds can use more complex trading strategies than ETFs and mutual funds so they have the potential for higher returns. In exchange, the management costs may also be higher.

Commodity vs Stock Trading

With commodity trading, using leverage is much more common than with stock trading. This means you only put down a percentage of the needed money for an investment. For example, rather than putting down the full $75,000 for the full value of an oil futures contract, you might put down 10% or $7,500.

The contract will require you to keep a minimum balance based on the expected value of your trade. If the market price starts moving in a direction where you are more likely to lose money, you would face a margin call and need to deposit more to get back to the trade’s required minimum value.

“Trading on margin can lead to greater returns than the stock market, but it can also lead to greater losses due to the leverage used,” says Turner. Small price moves lead to big changes for your investment return, meaning your potential for gain in the commodity market is high but so is your potential for losses.

Commodities also tend to be a short-term investment, especially if you enter a futures contract with a set deadline. This is in contrast to stocks and other market assets where buying and holding assets long term is more common.

In addition, you have more time to make trades with commodities because markets are open nearly 24/7. With stocks you primarily make trades during normal business hours, when the stock exchanges are open. You may have limited early access through premarket futures, but most stock trading occurs during normal business hours.

Overall, commodity trading tends to be more high-risk and speculative than stock trading, but it can also lead to faster, larger gains if your positions end up making money.

Should You Invest in Commodities?

Commodity investing is a strategy that’s best for sophisticated investors. Before making any trades, you need to carefully understand the commodity price charts and other forms of research. Since market price moves can lead to large gains and losses, you need a high risk tolerance as well, meaning you can stomach short-term losses in pursuit of long-term gains. And if you do invest in commodities, it should only be a portion of your total portfolio.

“For investors and traders who are looking to diversify their portfolio in an asset class that offers a higher risk/reward profile, many use about 20% or less of their portfolio for higher risk/reward,” says Turner. “That is the segment where commodity trading lives.”

Like with any decision, consider speaking with a financial advisor to see if investing in commodities is right for you and to get help on which strategies you should use.

Source: Forbes Advisor