Editor's Note: Options are not suitable for all investors. Options involve risks, including substantial risk of loss and the possibility an investor may lose the entire amount invested in a short period of time. Please see the Characteristics and Risks of Standardized Options.
Commodities trading — e.g. agricultural products, energy, and metals — can be profitable if you understand how the commodity markets work. Commodities trading is generally viewed as high risk, since the commodities markets can fluctuate dramatically owing to factors that are difficult to foresee (like weather) but influence supply and demand.
Nonetheless, commodity trading can be useful for diversification because commodities tend to have a low or even a negative correlation with asset classes like stocks and bonds. Commodities fall firmly in the category of alternative investments, and thus they may be better suited to some investors than others. Getting familiar with commodity trading basics can help investors manage risk vs. reward.
Key Points
• Commodities trading involves buying and selling raw materials like agricultural products, energy, and metals, which can be profitable with proper understanding of the markets.
• The commodities market is driven primarily by supply and demand, making it susceptible to volatility from unpredictable factors such as weather and global economic changes.
• Investors can engage in commodities trading through various methods, including futures contracts, stocks in related companies, ETFs, mutual funds, and index funds.
• The advantages of commodity trading include portfolio diversification and potential hedging against inflation, while the main disadvantage is the high risk associated with price volatility.
• Understanding personal risk tolerance is essential before investing in commodities, which may be more suitable for those comfortable with higher risk strategies.
What Is Commodities Trading?
Commodities trading simply means buying and selling a commodity on the open market. Commodities are raw materials that have a tangible economic value. For example, agricultural commodities include products like soybeans, wheat, and cotton. These, along with gold, silver, and other precious metals, are examples of physical commodities.
There are different ways commodity trading can work. Investing in commodities can involve trading futures, options trading, or investing in commodity-related stocks, exchange-traded funds (ETFs), mutual funds, or index funds. Different investments offer different strategies, risks, and potential costs that investors need to weigh before deciding how to invest in commodities.
Unique Traits of the Commodities Market
The commodities market is unique in that market prices are driven largely by supply and demand, less by market forces or events in the news. When supply for a particular commodity such as soybeans is low — perhaps owing to a drought — and demand for it is high, that typically results in upward price movements.
And when there’s an oversupply of a commodity such as oil, for example, and low demand owing to a warmer winter in some areas, that might send oil prices down.
Likewise, global economic development and technological innovations can cause a sudden shift in the demand for certain commodities like steel or gas or even certain agricultural products like sugar.
Thus, investing in commodities can be riskier because they’re susceptible to volatility based on factors that can be hard to anticipate. For example, a change in weather patterns can impact crop yields, or sudden demand for a new consumer product can drive up the price of a certain metal required to make that product.
Even a relatively stable commodity such as gold can be affected by rising or falling interest rates, or changes in the value of the U.S. dollar.
In the case of any commodity, it’s important to remember that you’re often dealing with tangible, raw materials that typically don’t behave the way other investments or markets tend to.
Commodity vs Stock Trading
The main difference in stock trading vs commodity trading lies in what’s being traded. When trading stocks, you’re trading ownership shares in a particular company. If you’re trading commodities, you’re trading the physical goods that those companies may use.
There’s also a difference in where you trade commodities vs. stocks. Stocks are traded on a stock exchange, such as the New York Stock Exchange (NYSE) or Nasdaq. Commodities and commodities futures are traded on a commodities exchange, such as the New York Mercantile Exchange (NYME) or the Chicago Mercantile Exchange (CME).
That said, and we’ll explore this more later in this guide, it’s possible to invest in commodities via certain stocks in companies that are active in those industries.
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Types of Commodities
Commodities are grouped together as an asset class but there are different types of commodities you may choose to invest in. There are two main categories of commodities: Hard commodities and soft commodities. Hard commodities are typically extracted from natural resources while soft commodities are grown or produced.
Agricultural Commodities
Agricultural commodities are soft commodities that are typically produced by farmers. Examples of agricultural commodities include rice, wheat, barley, oats, oranges, coffee beans, cotton, sugar, and cocoa. Lumber can also be included in the agricultural commodities category.
Needless to say, this sector is heavily dependent on seasonal changes, weather patterns, and climate conditions. Other factors may also come into play, like a virus that impacts cattle or pork. Population growth or decline in a certain area can likewise influence investment opportunities, if demand for certain products rises or falls.
Recommended: How to Invest in Agriculture
Livestock and Meat Commodities
Livestock and meat are given their own category in the commodity market. Examples of livestock and meat commodities include pork bellies, live cattle, poultry, live hogs, and feeder cattle. These are also considered soft commodities.
You may not think that seasonal factors or weather patterns could affect this market, but livestock and the steady production of meat requires the steady consumption of feed, typically based on corn or grain. Thus, this is another sector that can be vulnerable in unexpected ways.
Energy Commodities
Energy commodities are hard commodities. Examples of energy commodities include crude oil, natural gas, heating oil or propane, and products manufactured from petroleum, such as gasoline.
Here, investors need to be aware of certain economic and political factors that could influence oil and gas production, like a change in policy from OPEC (the Organization of the Petroleum Exporting Countries). New technology that supports alternative or green energy sources can also have a big impact on commodity prices in the energy sector.
Precious Metals and Industrial Metals
Metals commodities are also hard commodities. Types of metal commodities include precious metals such as gold, silver, and platinum. Industrial metals such as steel, copper, zinc, iron, and lead would also fit into this category.
Investors should be aware of factors like inflation, which might push people to buy precious metals as a hedge.
How to Trade Commodities
If you’re interested in how to trade commodities, there are different ways to go about it. It’s important to understand the risk involved, as well as your objectives. You can use that as a guideline for determining how much of your portfolio to dedicate to commodity trading, and which of the following strategies to consider.
Recommended: What Is Asset Allocation?
Trading Stocks in Commodities
If you’re already familiar with stock trading, purchasing shares of companies that have a commodities connection could be the simplest way to start investing.
For example, if you’re interested in gaining exposure to agricultural commodities or livestock and meat commodities, you may buy shares in companies that belong to the biotech, pesticide, or meat production industries.
Or, you might consider purchasing oil stocks or mining stocks if you’re more interested in the energy stocks and precious or industrial metals commodities markets.
Trading commodities stocks is the same as trading shares of any other stock. The difference is that you’re specifically targeting companies that are related to the commodities markets in some way. This requires understanding both the potential of the company, as well as the potential impact of fluctuations in the underlying commodity.
You can trade commodities stocks on margin for even more purchasing power. This means borrowing money from your brokerage to trade, which you must repay. This could result in bigger profits, though a drop in stock prices could trigger a margin call.
Futures Trading in Commodities
A futures contract represents an agreement to buy or sell a certain commodity at a specific price at a future date. The producers of raw materials make commodities futures contracts available for trade to investors.
So, for example, an orange grower might sell a futures contract agreeing to sell a certain amount of their crop for a set price. A company that sells orange juice could then buy that contract to purchase those oranges for production at that price.
This type of futures trading involves the exchange of physical commodities or raw materials. For the everyday investor, futures trading in commodities typically doesn’t mean you plan to take delivery of two tons of coffee beans or 4,000 bushels of corn. Instead, you buy a futures contract with the intention of selling it before it expires.
Futures trading in commodities is speculative, as investors are making educated guesses about which way a commodity’s price will move at some point in the future. Similar to trading commodities stocks, commodities futures can also be traded on margin. But again, this could mean taking more risk if the price of a commodity doesn’t move the way you expect it to.
Trading ETFs in Commodities
Commodity ETFs (or exchange-traded funds) can simplify commodities trading. When you purchase a commodity ETF you’re buying a basket of securities. These can target a picture type of commodities, such as metals or energy, or offer exposure to a broad cross-section of the commodities market.
A commodity ETF can offer simplified diversification though it’s important to understand what you own. For example, a commodities ETF that includes options or commodities futures contracts may carry a higher degree of risk compared to an ETF that includes commodities companies, such as oil and gas companies, or food producers.
Recommended: How to Trade ETFs
Investing in Mutual and Index Funds in Commodities
Mutual funds and index funds offer another entry point to commodities investing. Like ETFs, mutual funds and index funds can allow you to own a basket of commodities securities for easier diversification. But actively managed mutual funds offer investors access to very different strategies compared with index funds.
Actively managed funds follow an active management strategy, typically led by a portfolio manager who selects individual securities for the fund. So investing in a commodities mutual fund that’s focused on water or corn, for example, could give you exposure to different companies that build technologies or equipment related to water sustainability or corn production.
By contrast, index mutual funds are passive, and simply mirror the performance of a market index.
Even though these funds allow you to invest in a portfolio of different securities, remember that commodities mutual funds and index funds are still speculative, so it’s important to understand the risk profile of the fund’s underlying holdings.
Commodity Pools
A commodity pool is a private pool of money contributed by multiple investors for the purpose of speculating in futures trading, swaps, or options trading. A commodity pool operator (CPO) is the gatekeeper: The CPO is responsible for soliciting investors to join the pool and managing the money that’s invested.
Trading through a commodity pool could give you more purchasing power since multiple investors contribute funds. Investors share in both the profits and the losses, so your ability to make money this way can hinge on the skills and expertise of the CPO. For that reason, it’s important to do the appropriate due diligence. Most CPOs should be registered with the National Futures Association (NFA). You can check a CPO’s registration status and background using the NFA website.
💡 Quick Tip: Did you know that opening a brokerage account typically doesn’t come with any setup costs? Often, the only requirement to open a brokerage account — aside from providing personal details — is making an initial deposit.
Advantages and Disadvantages of Commodity Trading
Investing in commodities has its pros and cons like anything else, and they’re not necessarily right for every investor. If you’ve never traded commodities before it’s important to understand what’s good — and potentially not so good — about this market.
Advantages of Commodity Trading
Commodities can add diversification to a portfolio which can help with risk management. Since commodities have low correlation to the price movements of traditional asset classes like stocks and bonds they may be more insulated from the stock volatility that can affect those markets.
Supply and demand, not market conditions, drive commodities prices which can help make them resilient throughout a changing business cycle.
Trading commodities can also help investors hedge against rising inflation. Commodity prices and inflation move together. So if consumer prices are rising commodity prices follow suit. If you invest in commodities, that can help your returns keep pace with inflation so there’s less erosion of your purchasing power.
Disadvantages of Commodity Trading
The biggest downside associated with commodities trading is that it’s high risk. Changes in supply and demand can dramatically affect pricing in the commodity market which can directly impact your returns. That means commodities that only seem to go up and up in price can also come crashing back down in a relatively short time frame.
There is also a risk inherent to commodities trading, which is the possibility of ending up with a delivery of the physical commodity itself if you don’t close out the position. You could also be on the hook to sell the commodity.
Aside from that, commodities don’t offer any benefits in terms of dividend or interest payments. While you could generate dividend income with stocks or interest income from bonds, your ability to make money with commodities is based solely on buying them low and selling high.
The Takeaway
Commodities trading could be lucrative but it’s important to understand what kind of risk it entails. Commodities trading is a high-risk strategy so it may work better for investors who have a greater comfort with risk, versus those who are more conservative. Thinking through your risk tolerance, risk capacity, and timeline for investing can help you decide whether it makes sense to invest in commodities.
Fortunately, there are a number of ways to invest in commodities, including futures and options (which are a bit more complex), as well as stocks, ETFs, mutual and index funds — securities that may be more familiar.
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