Commodities. The price of commodities impacts the price of the products and goods consumers use. Supply and demand are the key drivers, but many factors affect that supply and demand. There are also opportunities for investing in commodities if you want in on the action, but risks are involved.
This article will guide you through the world of commodities and ways to invest in commodities. We will also cover why it is risky to invest in a commodity, so you can take a balanced approach if you decide to add this asset class to your financial portfolio.
What Are Commodities?
The best way to define a commodity is that they are raw materials and goods commonly used in and as products purchased by consumers. Common is the keyword here, as they are commonly used and widely distributed. They are also a separate asset class that traded around the world. Companies will trade commodities to lock in prices and hedge costs, while traders seek to profit from the incremental price fluctuations. Commodities have the same uniform standard quality, making them interchangeable and tradeable regardless of who produced them.
Commodity traders often use leverage, increasing the risks even on small incremental price movements. Leverage involves using borrowed capital to purchase more contracts for a smaller investment. Leverage can lead to large profits but equally large and swift losses if the commodity price moves against you.
There are many different types of commodities and ways to trade them. The common belief is to trade commodity futures or options, but there are more diverse ways to trade them like stocks, exchange-traded funds (ETFs) and mutual funds.
Traditional commodities are traded on exchanges like the Chicago Mercantile Exchange (CME), New York Mercantile Exchange (NYMEX) or the London Metal Exchange (LME). Futures contracts enable producers and consumers of commodities to manage their price risks effectively.
Why Invest in Commodities?
There are many viable reasons to invest in commodities. Like any investment, the goal is to benefit from price appreciation. However, commodities can also provide more benefits, such as:
- Inflation hedge: Commodities benefit from inflation as they lift the value of the underlying product. Rising commodity prices result in rising prices for commercial products and goods. As a consumer, you have to pay higher prices when inflation rises. However, as an investor, you can invest in commodities to benefit from rising prices. You can profit from inflation while hedging yourself from falling buying power and investment values.
- Diversification: Commodities are generally a whole different asset class. Commodities are an asset class like stocks, options, futures and bonds. However, you can invest in them through futures, options and stocks. Weigh the risks regarding the type of investment in commodities, as some carry more volatility and leverage than others.
- Speculation: The leverage ratio for trading commodities certainly draws in many speculators. Who could resist investing a small amount with the potential to make a huge amount back? While risk capital is recommended, the leverage can tweak returns much higher than the small investment needed. Leverage ratios of 10:1 are common, as some brokers offer even more, making the return on investment (ROI) extremely tempting. However, when dealing with margin, there's always the risk of losing more than you invested. There's no doubt that commodities draw many gamblers. Therefore, it's best to quantify your risks on every trade and discipline yourself to cut losses while they are small before they grow too large.
Types of Commodities
There are over several hundred commodities that are tradeable around the world. You will only want to trade some of them. Liquidity is an important factor in any financial market. Sticking to the four main categories and the more widely traded commodities is best to ensure proper liquidity. Commodities are usually traded in futures contracts, enabling speculators to trade them and buyers to take delivery or hedge prices.
Industrial metals are base metals used in industrial applications. These include metals like iron ore, steel, nickel, lead, copper, aluminum and zinc. Precious metals are rare and tend to have a relatively high value. The common precious metals are gold, silver and platinum. Precious metals also have industrial applications beyond jewelry. Like platinum is used in catalytic converters in cars. Gold is used in electronics and currency fluctuations often impact them. Metals trade on commodity exchanges, usually as futures contracts.
Agriculture commodities are products that are grown and harvested or raised on farms. They are generally consumed by people or animals or used in the textile and biofuel industry. They generally fall into one of three categories: crops, livestock and daily. Crops can include sugar, corn, soybeans, wheat and sugar. Livestock includes cattle, pork bellies and eggs. Dairy includes milk, cheese, butter and whey.
Learn more: Investing in Coffee: Great Strategies to Consider and 10 Best Sugar Stocks to Buy Now
Energy is one of the heaviest-traded commodity types, including crude oil, natural gas, gasoline and coal. Crude oil comprised of Brent crude oil, West Texas intermediaries (WTI) crude oil and natural gas are two of the heaviest traded and most liquid commodities. Brent crude is the most heavily traded commodity in the world, as it trades over a million contracts daily. It accounts for two-thirds of the global oil pricing extracted from the North Sea. Brent crude gets refined into gasoline and diesel fuel.
Forest products like lumber, timber and wood materials are agricultural commodities because they must be grown, cultivated and harvested like crops and livestock. They are a renewable resource. However, wood is not meant for consumption. People use forest products for paper and packaging materials, laminates, furniture for houses, and for bridges and buildings. These factors led to it having its category. Traders may use futures or options to trade forest products.
How Supply and Demand Affect Commodities
Supply and demand impact commodity prices.
Supply refers to the available amount of a commodity that producers are able and willing to sell. Many factors, such as input costs, technology advances, natural events and production costs, can impact supply. Demand refers to the commodities consumers want and are willing to buy.
Factors impacting demand include consumer income, taste preferences, trends and prices. The price should rise when demand is strong while supply is moderate or falling. When demand is weak, while supply is heavy, prices should fall.
Commodity trading involves the use of leverage through margin accounts. Leverage is a double-edged sword in that it can amplify profits on one hand but also has the power to blow out accounts if not managed correctly. It amplifies the size of profits and losses. Risk management and the discipline necessary to cut losses are crucial when trading commodities. It's imperative to be aware of the risks of using heavy leverage like 10:1 or 10% intraday margin.
For example, if you put down 10% on a $50,000 commodities contract, a move resulting in more than a $5,000 swing against you will trigger a margin call. Depending on the brokerage policies, your broker may issue a margin call ahead of it, triggering and triggering a forced liquidation where the platform automatically cuts your losses. Make sure you are aware of your broker's margin policies.
Ways to Invest in Commodities
So you've decided to allocate some of your portfolio to commodities. The question now is which form of investment would suit you best and how to buy commodities. There are generally five ways to invest in commodities.
The spot market, or the cash or physical market, is when trades settle on the spot. This means the commodity is delivered immediately. Spot prices are the current and present price of the commodity. The U.S. stock market is also a spot market where securities are bought and sold on the spot price and delivered electronically and immediately to and from your account.
The main participants in the spot market are producers, consumers and traders. Producers produce the commodity and try to sell their commodities as soon as they're produced for the best price. Consumers are entities that utilize commodities for their business, including food manufacturers that buy wheat on the spot for their bread-making operations. Traders and investors try to capitalize on price fluctuations of the commodities without actually taking delivery of the physical commodity.
Commodity futures prices require a subscription to various exchanges like the CME. Futures contracts are an agreement to buy or sell a specific commodity at a specified price by a specified time. Investors use this primary instrument to trade commodities through the CME and Intercontinental Exchange (ICE) exchanges.
Commodity index futures are futures based on a commodity index. They let investors speculate on the overall direction of commodity prices versus individual commodities. Most tend to trade rather than invest in futures. To learn about commodity futures, it helps to visit commodity trading websites of the exchanges.
Options contracts are similar to futures contracts in that they are a right, not an obligation, to buy or sell a commodity at a specified strike price up to a specific expiration date.
Stock investors can invest in the companies that produce or trade the commodity. Since these are businesses, the stock price moves following its earnings performance and not necessarily the price fluctuations in the commodities associated with the company. For example, gold investors may buy gold miners as their gold stocks.
Exchange-Traded Funds (ETFs)
You can also invest in commodity funds through exchange-traded funds (ETFs). These are ways to invest in commodities through a stock that tracks the underlying commodity prices. These tend to be less volatile than the actual futures contract allowing investors to hold them in a portfolio. These are the most accessible if you want to learn how to invest in a commodity.
Physical ownership involves taking delivery of the physical commodity. Investors will not likely take this route unless it involves precious metals like gold or silver. There are storage, logistics and maintenance costs involved. Producers, manufacturers and farmers tend to transact taking and providing delivery for the actual commodity.
Example of Investing in Commodities
Let's say you think oil prices will rise. There are many ways to invest based on your directional stance, such as through light crude futures contracts, which can be volatile and use extensive margins. You could also take an options contract long, but they are more risky as you can lose money if the contract falls under the strike price. While it costs less capital, you can lose more percentage-wise. If you're familiar with and more comfortable investing in stocks, you could buy an oil ETF like the United States Oil Fund (NYSEARCA: USO).
The weekly USO candlestick chart illustrates a potential bull flag breakout. We can analyze the chart to interpret price action and plan potential entry price levels. The weekly bull flag formed after its parabolic spike to the $92.20 peak in June 2022. USO sold off from the peak, forming lower highs on bounces and lower lows on falls. The weekly relative strength index (RSI) momentum oscillator fell from the overbought 82-band in February 2022 to the 40-band in September 2022. Drawing parallel lines connecting the highs and lows creates the flag. The breakout attempt through the upper trendline at $68.09 is powered by the weekly RSI rising towards the 60-band.
The weekly 20-period exponential moving average (EMA) has support at $65.87, and the weekly 50-period MA resistance is testing at $67.99. The pullback support levels are areas of support to consider buying some USO. They are at $64.90, $61.81, $57.83, and $52.46 weekly market structure low (MSL) trigger and $46.16. A little can be bought at each level on pullbacks, or a position at the front two supports can be taken since a deeper pullback may not be in the cards.
Pros and Cons of Investing in Commodities
Here are the pros and cons of investing in commodities.
The upside of investing in commodities include:
- High percentage returns: Since commodities futures and options utilize leverage, you can use a smaller amount of capital to buy a larger position. If the position moves favorably, the percentage return can be very large relative to the capital invested.
- Inflation hedge: If you can't beat them, join them. Since commodities prices rise with inflation, an investment in commodities enables you to capitalize on growing inflation. This helps offset losses in your portfolio if your stocks are hurt by inflation. It offsets your loss of buying power at the grocery store and for retail products. You can hedge against positions by shorting commodities, which can be extra risky.
- Diversification: Since commodities are a different asset class, investing in them offers diversification. Diversification helps you spread the risk and avoid having too much concentration in one industry, sector or asset. It can also be a relief not to have to stay on top of earnings reports and performance when trading commodity futures.
Here are the downsides of investing in commodities:
- Leverage: Why is it risky to invest in a commodity? Leverage. This can be both a pro and a con because of the danger it can present to your account. Commodity futures can have leverage of 10:1, which means an incremental move against you can trigger a margin call. Discipline yourself take stop-losses to avoid turning a small loss into a giant one.
- No dividend income: Investors accustomed to collecting income through dividends likely won't like commodities since they don't pay dividends or interest. If you play to the long side, the only way to profit is through price appreciation.
- Complex markets: Commodities markets can be affected by economic and geopolitical factors. Understanding concepts like backwardation, contango, front month and rollovers is also important.
Tips for Investing in Commodities
When investing in commodities, make sure to educate yourself first before taking any trades. Familiarize yourself with the commodity and then the catalysts that can move prices up or down.
For example, crude oil moves up when OPEC cuts production and tends to fall when they raise production. Decide how much risk you can handle and decide how to invest. Risk-tolerant investors may choose futures contracts, while risk-averse investors may opt to invest in a commodity ETF. Be very aware of the risks, especially when using margin.
Always be aware of your maintenance margin and proximity to falling below it to avoid margin calls. Most importantly, be disciplined to patiently wait for entries, not chase and keep stop-losses as soon as they trigger.
Start on a Simulator
As with any new asset class, start slowly. If you want to trade commodity futures, start on a simulator to work on signal tracking and risk management.
Remember that getting complacent on a simulator is easy since you can't lose money, but treat it as you would a money trade. When you start trading money, you don't want to be a deer in the headlights freezing up when unexpected volatility hits. Once you decide to trade with real money, start very small to avoid getting into panic situations. Trading is a mental game.
Here are answers to some frequently asked questions.
Are commodities worth investing in?
Commodities can be worth investing in for risk-tolerant investors. Understanding the risks associated with your commodity and being aware of the positive and negative catalysts that can move prices is important. There are various ways to invest in commodities to tamp down the volatility and risk if you want to invest. Commodities investment takes a more active management style and the discipline to cut losses quickly.
What is a good commodity to invest in?
That depends on your investment criteria, risk profile and goals. For long-term investors, gold is a commodity someone may invest in. It has been a strong commodity that tends to weather economic downturns and geopolitical events.
Can you make money investing in commodities?
You can make money investing in commodities but also lose money. Should you invest in commodities right now, make sure to be well aware of the risks. Like any investment, it's best to educate yourself about the asset and scale into the investment slowly. Commodities tend to trend often, making it suitable for swing traders using a trend-following system.