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Commodities markets differ from other investments. They are real assets, have an intrinsic value, and provide utility by use in industrial manufacturing. Commodities are the raw material that is either used in the production of goods and services or consumed directly.
There Are Two Main Types:
1. Hard commodities include precious metals and energy.
2. Soft commodities consist of livestock and agriculture. Both depend on the weather factor.
Market Players
We classified participants as:
1. Speculators (traders): are present in all markets. For example, they can be interested in a specific commodity because they think that the price will go up at a certain time, so they want to obtain a benefit by selling it at a higher price. They relate the interest to the opportunity to get an earning.
2. Hedgers: People who are involved in the commodities market (i.e., farmers). These players enter this market because they can warranty a commodity price (for sale or purchase). The main objective is to hedge their costs by establishing a future sell price, thus reducing business uncertainty.
3. Arbitrageurs: People who invest in commodities to hedge their position that can be linked or not into the commodity market. The main objective is to obtain riskless profits by finding market inefficiencies.
Which Is the Most Common Way to Trade Commodities?
For sophisticated and experienced investors, there are two direct vehicles to invest in. One is through future commodities markets. The retail investor can get involved through a commodity trading advisor (CTA) or a commodity pool operator (CPO). The last one manages the funds of several clients under one particular account. Another way is by using market indexes, which are benchmarks that track a list of commodities. This allows the trader to diversify risk by investing in different commodity types.
On the other hand, another alternative is buying a physical commodity. But unless you can store them, this option is not convenient for most traders. The average investor can only store a limited number of commodities in an easy way, such as gold or silver.
Another convenient way is investing in stocks from companies that use the raw material to produce other goods. The investor who wants to trade must take into account not only the performance of the commodity but also other business factors like the margins of the company, the management, etc. The company’s stock value correlates to the business and the supply and demand of that commodity. For example, if an oil company discovers a new oil source and the world demand is increasing, then the company’s stock price is expected to rise.
Last but not least, ETFs or Mutual funds are a simpler way to invest since the broker will take care of all the financial management. The trader will only worry about which fund is the right fit based on his investing profile.
There Are 2 Main Reasons to Consider Investing in Commodities.
1. Commodities fall into the inelastic goods category. These are essential to consumers that even changes in price have a limited effect on supply and demand.
2. Commodities tend to act as a safe heaven for investors. We consider gold and silver stores of value when negative events occur worldwide.
3. Investors use commodities as a hedge for inflation. The irony is that it benefits from inflation. For example, there is a direct correlation between gold and the inflation rate.
However, investing is about managing the risk involved. Some of them are:
Geopolitical | The natural resources to produce the raw material are in different countries. That is why the jurisdiction relies on various governments, companies, and other entities. |
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Speculative | Because these kinds of investors are interested in making profits, they tend to move the market in different ways and therefore increase volatility |
Corporate governance risk | It is related to corporate fraud. Investors should be careful with where they put their money. |
Some recommendations to manage these risks are performing due diligence and diversifying your portfolio among asset classes.
To trade commodities, investors need to understand which factors affect the prices. Some examples are politics, macroeconomics, seasonality, competition, and weather. Also, they should choose a commodity that is not affected by more than 3 of that criteria.
