Commodities are the naturally occurring raw materials that are used for manufacturing, production and the consumption of food. They are traded physically on exchanges or through derivative products and funds.
What are commodities?
Commodities are the raw materials that are used as the building blocks for other processes. Processes can include the manufacture of goods and materials, the construction of infrastructure, of the production of food. However, commodities can also be used for investment purposes too.
Commodities are fungible. This means that they are considered to be entirely interchangeable with other commodities of the same type. It means that commodities prices do not vary around the world. Sugar grown in Brazil has the same value as sugar that is grown in India.
Subsequently, commodities are shipped around the world and are a crucial gauge of the global economy. They can be bought and sold on exchanges but also through financial institutions.
Various types of commodities can be traded
Commodities are categorised as being in two groups, with hard and soft commodities.
“Hard” commodities are mined or extracted from deep in the ground. They are metals, minerals and energy products. Here are a few examples:
- Precious metals – Gold, Silver, Platinum, Palladium
- Base Metals – Copper, Iron Ore, Nickel
- Energy – Crude oil, Natural Gas
- Minerals – Diamonds
“Soft” commodities are cultivated or farmed. They are agricultural products or materials. Here are a few examples:
- Grains – Wheat, Corn, Rape seed
- Crops – Sugar, Coffee, Orange Juice
- Livestock – Pork, Cattle
- Materials – Cotton
Ways to get exposed to commodities
Commodities have been traded on markets and exchanges for centuries. However, retail traders would tend not to want to take physical ownership of a tonne of copper or a barrel of oil. Subsequently, financial institutions have devised derivatives and funds that allow traders to have exposure to the commodities markets without the requirement to take delivery of the commodities.
Here is how trades can be exposed to commodities:
- Contracts For Difference – Retail traders are more likely to prefer trading CFDs. You can buy and sell commodities to take advantage of shorter-term price rises and falls. CFDs are a leveraged product, allowing traders to increase their exposure by trading on margin.
- Exchange Traded Funds – Investing in commodity funds allow for a relatively cheap way to invest in commodities.
- Stocks – Investing in companies that have business in raw materials or extraction is another popular way for retail traders to have exposure to commodities.
- Futures markets – Sophisticated investors can trade commodity futures
The pros and cons of trading commodities
Commodities are seen as relatively high-risk investments. That can come with some positives but also some risks. Let’s have a look at a few of the pros and cons of trading or investing in commodities.
Pros:
- Improve diversification – adding commodity investments can increase diversification to a portfolio
- Increased returns – The higher-risk nature of commodities can allow for improved returns, especially if a portfolio is packed with higher-yielding, defensive investments.
- Inflation hedge – Commodities can be positively correlated with inflation. This means that when other investments underperform during times of high inflation (such as bonds and stocks), commodities can help to be a hedge for a portfolio.
Cons:
- Elevated volatility – As a high-risk investment, this increases volatility. It means that the investments are highly tuned to shifts in the outlook of the global economy, politics and geopolitics
- Unpredictable nature – The outlook for some commodities (especially softs) can be significantly impacted by unpredictable natural events such as natural disasters, weather patterns etc.
- Higher risk – Single commodity ETFs carry a higher risk profile than multi-asset ETFs.
