What Is A Commodity & The Role Of It In The Stock Market

Commodities are one of the major asset classes that play a distinct role in financial markets. Given its performance and correspondence to the stocks and bonds market, many financial professionals will buy and sell commodities as a way to hedge against market volatility and take advantage of the performance of underlying assets. 

Many may be confused about what a commodity is, or if they actually have to take receipt of the commodity when the contract expires. So, continue reading below to learn more about the commodities market, and why investors like to have some exposure to this asset class. 

What is a Commodity?

Commodities are often raw materials that are used to manufacture products and goods that are then sold to consumers. 

Commodities may come from different producers, though the nature of it means that it’s interchangeable with others and is essentially uniform across the board. Essentially, this means that the iron or precious metals you get from one producer will largely be the same quality as the iron you can get from another producer. 

Plus, when commodities are traded on a commodities exchange, they must meet certain standards and be of the same grade, referred to as basis grade. 

Different Types of Commodities

You still may be uncertain about what constitutes a commodity, so let’s go over the main types of popular commodities that can be traded

Hard Commodities

The first type of commodity we’ll discuss are hard commodities, which are commonly metal and energy commodities like oil, iron, precious metals, and other natural resources. These are inputs that won’t go bad after sitting on the shelf for a long time, and can still be utilized by manufacturers no matter how long they’ve been sitting. 

Soft Commodities

The other types of commodities are soft commodities, which are items that cannot be stored for a long time. This can include commodities like sugar, cocoa, coffee, and cotton, all of which will expire after a certain amount of time. As you’ll see, many agricultural commodities are included in this list since they can spoil and go bad before they get used. 

What is Commodity Trading?

With a better understanding of what commodities are and the different types that exist, let’s go over commodity trading. Commodities can be bought and sold on certain exchanges as financial assets. Plus, the space has now evolved to include an advanced commodity derivatives market where you can purchase contracts like forwards, options, and futures on commodities. 

This practice goes back hundreds of years when farmers would haul livestock and produce to the local market and sell commodities directly to buyers at an agree price. Prices would fluctuate depending on the supply, demand, and other market factors that affected the underlying assets. 

Since then, the commodities market has become standardized, which led to commodity futures exchanges. Nowadays, futures and options contracts on commodities can be traded all around the globe on major exchanges, including metals, energy, agricultural products, and more. 

Nowadays, investors can invest in a particular commodity in a number of different ways, including the commodities futures market, commodity ETFs, mutual funds, and more. 

Read more: Best Commodities Broker 2024

How Does Commodity Trading Work?

Now that you know a little bit more about the types of commodities like hard and soft commodities, and what commodity trading is, let’s discuss how you can buy and sell commodities. 

The purchase and sale of commodities typically involve commodity futures contracts on exchanges that are built for standardizing the quantity and quality of commodities, like the New York Mercantile Exchange, the Chicago Mercantile Exchange, the London Metal Exchange, or the Chicago Board of Trade. 

With a futures contract, there is a buyer and producer of the commodity, who utilize futures contracts for hedging purposes. When the futures contract expires, they will make or receive the delivery of the actual commodity. 

Aside from buyers and producers of hard and soft commodities, there are also speculators in the commodity exchange market. They trade commodity futures contracts to take advantage of volatility in commodity prices. With this, these tradersdon’t intend to actually take delivery of the commodities upon the expiration of the contract, such as crude oil, precious metals, natural gas, heating oil, lean hogs or other basic goods and soft or hard commodities that can be traded by individual investors. 

Read more: Best Futures Trading Platform 2024

Commodity Futures Trading Commission (CFTC)

The overseeing governing body for the commodity markets is the Commodity Futures Trading Commission (CFTC). Their job is to promote the ‘integrity, resilience, and vibrancy of the U.S. derivatives markets through sound regulation.’

What are The Most-Traded Commodities?

As you can see, there are many types of commodities that can be traded in the commodities markets, so which ones are the most popular among investors?

At this point in time, examples of commodities that have the most-traded futures contracts on the commodity exchange market are crude oil, natural gas, soybeans, corn, gold, copper, and silver. 

Again, many traders of commodity derivatives today are speculators, meaning they don’t actually have to take receipt of the commodity, they are merely speculating on the volatile prices of the underlying asset. 

The Benefits of Trading Commodities

There are many reasons why traders decide to trade commodities futures contracts as a way to diversify their investment portfolio. 

One of the reasons why commodity traders like to invest in them is that they’re a great hedge for inflation. This is because commodity prices tend to rise when inflation increases, so investors can get a lift from the return on rising oil prices or other commodities, even if the stock market is suffering from the same market forces. Thus, commodities are one of the only asset classes that actually benefits during inflationary times and can provide investors with sizable returns. 

Even outside of inflationary periods, commodities don’t generally have a strong correlation with stocks or bonds, which are other major asset classes that investors generally have exposure to. So, investing in commodities can provide some diversification from many asset classes that they wouldn’t be able to get otherwise. 

Plus, given the modernization of the markets today, it’s easy to get exposure to a valuable commodity through mutual funds or ETFs. Thus, even though it can be a very complex and dynamic market, it’s not entirely out of reach for everyday investors to benefit from. 

The Risks of Trading Commodities

Just like trading any other assets, there are some risks associated with participating in the commodities markets. One of the most common risks is commodity price risk, which is the chance that the price of the commodity will change quickly and incur losses for either the buyers or the producers of the commodity. 

Some buyers may be surprised if commodity prices are higher than expected at the agreed price when the future date arrives. On the other hand, producers have the price risk that the prices tank, so they may have lower profitability from selling an equal amount of the same commodity than they did in the previous period. 

In either case, it’s important to realize that both parties have risks at play when trading a commodity, they’re just typically on opposite ends of the spectrum. The same is true for many asset classes, as timing in the markets and knowing when to buy, sell or trade a good or asset can be very consequential to profit levels. 

Factors That Affect Commodity Prices

There are many factors out there that can affect commodity price movements, especially given the number of commodities that are out there and how they’re produced. 

Namely, the supply and demand of commodities is the main determinant of what impacts their prices. Consider a time when the economy is on the rise and there is a large demand for oil, so oil prices increase. On the other hand, if the economy is shrinking and there isn’t a lot of demand for the commodity, prices would likely decrease. 

There are many other things that can impact the supply and demand of commodities, and therefore their price. 

For instance, agricultural commodities can be greatly affected by natural disasters like crop flooding, tornadoes, and more that impede agricultural commodity production. Other commodities like a raw material may be impacted if a certain producer goes out of business, or regulations pass that limit the production of the given commodity. 

In any case, individual investors need to be aware of the factors that can impact the certain commodities they’re investing in, just like when you’re investing in a particular stock of a company. But, keep in mind that the factors that impact commodity markets’ price movements of hard commodities likely won’t be the same for soft commodities. However, even the most valuable commodity can be impacted by external factors. 

Final Thoughts

The commodity markets play a very important role in the overall financial markets, offering investors a way to diversify their portfolios and even hedge against inflation. While this market has humble beginnings that started with just agricultural products and raw materials in simple markets, it has now grown to an advanced and sophisticated aspect of the modern financial world. 

Most of the time, investors who trade commodities are speculators, not actually taking possession of the commodities upon expiration of the contract; rather, they participate in the commodity futures markets as a way to take advantage of price volatility in the commodities exchanges. 

There are a number of commodities exchanges where you can trade commodity futures, including the New York Mercantile Exchange, the Chicago Board of Trade, the Chicago Mercantile Exchange, the London Metal Exchange, and more. Plus, there are many mutual funds and ETFs where you can invest in commodity derivatives without having to enter the trades or futures contracts on your own.

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