What Is a Commodity?

A commodity is a basic good used in commerce that is interchangeable with other goods of the same type. Things are most often used as inputs in the production of other goods or services. The quality of a given commodity may differ slightly, but it is essentially uniform across producers. When traded on an exchange, items must also meet specified minimum standards, known as a basis grade.

Understanding Commodities

Commodities are used as materials in the production of goods or services.

A commodity has monetary utility and is considered a physical asset.

Commodity examples include those that plucked from the ground and those that have to be dug up deep underground.

Typical commodities include:

  • “Energy” (crude oil, gasoline, heating oil, natural gas)
  • “Metals” (gold, silver, copper, platinum, palladium)
  • “Softs” (cocoa, coffee, cotton, orange juice, sugar)
  • “Grains and Oilseeds” (corn, soybeans, soybean meal, soybean oil, wheat)
  • “Livestock / Meats” (feeder cattle, live cattle, lean hogs)
  • “Other” (lumber, dairy products)

Crude oil is currently the world’s most actively traded.

Commodities are traded on an exchange.

The main three global commodities markets are the:

  • CME Group (formed from the merger of the Chicago Mercantile Exchange and the Chicago Board of Trade)
  • Intercontinental Exchange
  • London Metal Exchange

For trading purposes, a given commodity typically is interchangeable.

One barrel of oil is considered the same as any other.

A commodity must be interchangeable with another item of the same type and grade to be traded on the markets.

That means that to a trader, gold is gold: no matter where it was mined or which company mined it.

The term for this quality in commodities is fungible.

They are split into two varieties:

  1. Hard commodities are metals or energy resources, mined or extracted from natural resources. Soft commodities are agricultural, farmed, or grown.
  2. Soft commodities tend to be seasonal and prone to spoilage.

The buying and selling of commodities for profit are known as commodities trading.

Commodities trading is split into two types:

  1. The spot market
  2. The futures market

The spot market is used for commodities that will be delivered immediately, and the futures market is for items that will be provided at some point in the future.

Most commodities traders are speculators and do not wish to deliver the commodities they are trading, so most futures contracts are closed before their delivery date.

Futures contracts are traded on futures exchanges, with most commodities being associated with a specific local business.

Who Trades Commodities?

There are two broad types of commodity market participants:

  • Hedgers (aka “commercials”). These are businesses that are actually producing, shipping, processing, or otherwise handling the commodities in question. They include oil and gas producers and refiners, miners, grain millers, farmers, and meatpackers.
  • Speculators. These include banks, hedge funds, and individuals who trade commodities. They speculate that the price of an item will go up or down within a specific time frame, and they place trades to turn a profit.

How Do You Trade in Commodities?

Several routes into the commodities markets for individual traders don't involve planting your corn or raising your pigs.

These include:

  • Futures contracts. A futures contract is an agreement to buy or sell a certain amount of a commodity at a specific price in the future. If the price of a futures contract rises, the buyer, in theory, can profit; in contrast, the seller of a futures contract potentially earnings if the price goes down (this is known as going short). In futures markets for retail traders, actual “delivery” of a commodity is rarely allowed; usually, contracts are “closed out” before expiration.
  • Options on futures. Put or call options based on crude or gold, for example, are traded on many futures exchanges. These contracts grant the holder the right, but not the obligation, to buy or sell a specific futures contract at a particular price on or before an expiration date.
  • Exchange-traded funds (ETFs). ETFs are marketable securities that trade like common stocks and can be bought or sold on an exchange. Many ETFs are linked to a single commodity, a basket of things, or a commodity index.
  • Traditional stocks. Many publicly traded companies have direct exposure to commodities and commodity markets (miners, oilseed processors, oil and gas exploration companies, for example) or indirect exposure (farm equipment manufacturers).

As you can see, not only that commodities are bought and sold there on a “spot”’ on an immediate purchase and payment basis.

There are also ‘forward contracts’ enabling products to be bought and sold at a fixed price for delivery at a particular future time.

And there are also ‘options’ and ‘futures.’ An option allows a party to buy or sell at a future time but not the obligation to do so. Futures are similar, but they require parties to deliver a commodity or pay for it.

It is easy to see that options and futures are like bets on the future price on which they are constructed. As a result, they can be used for hedging of “real” trades. For example, an airline might buy a forward contract or choose an option or a future to lock in the future price of its fuel.

But these commodities derivatives are also opportunities to speculate – buying or selling- believing that price changes will be profitable. If you can hedge your bet using an option or a future, much is better (or safer).

Private investors can gain exposure to the commodities markets by investing in funds that, in turn, invest in commodities.

An increasingly popular form of commodity investment is stock market listed exchange-traded funds (ETFs).

You can buy and sell shares in ETFs, backed by physical commodities, just like any shares.

The charges levied by the managers of ETFs are lower compared to other investment funds, and the process of buying into them or selling out is much quicker and easier.