Commodities Trading: An Overview

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25 Aug, 2021

9 min read

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Commodities serve a key role in most of our lives.

A Brief Overview

A commodity can be understood to be any basic good that is used in commerce that can be changed with other goods that fall into the same category as the good in question. Some of the more prominently interchanged commodities include crude oil, natural gas, grains, and gold. 

Investors take advantage of commodities as they allow them to diversify their portfolios and move beyond more conventional securities. Owing to the fact that the price of commodities is known to gravitate in the opposite direction of stocks, some investors may take advantage of commodities during instances of volatility in the market. 

Previously, to partake in commodity trading you were required to invest considerable time and money and be proficient in the markets. This meant that professional traders primarily dominated commodity trading. Today, there exists a broader range of opportunities to participate in the commodity markets.

A commodities exchange is used to refer to both a physical location as well as legal entities. The former refers to a place where commodities are traded.  The latter is used to help enforce rules pertaining to the trade of uniform commodity contracts and investment products related to the same.

India is home to a number of commodity exchanges including the Multi Commodity Exchange of India Limited (or MCX), National Commodity and Derivatives Exchange Limited, and the Universal Commodity Exchange.

Traits of the Commodities Market 

Commodity markets are known to feature the following traits.

  • These markets operate in accordance with supply and demand.
  • They are affected by global economic development.
  • Technological advances affect these markets.

Types of Commodities

Commodities that are traded can be understood to fall into four broad categories listed below.

Metals – Popular metals include gold and silver. They are often invested in during times of market volatility, rising inflation, and/or in instances of a currency falling in value owing to their reliable and conveyable worth.

Energy – Crude oil, gasoline, and natural gas fall under this category. Economic developments across the globe interspersed with the falling output of oil from oil wells across the world have led to hikes in the prices of oil. Alternative sources of energy and new technological developments can impact the market prices of commodities operating within this sector such as crude oil prices.

Livestock and Meat - Dairy products fall under this category. Their prices too are affected by demand and supply.

Agriculture – Wheat, cocoa, coffee, cotton, and sugar are popular commodities. This sector can be more volatile during certain points in a year when there is a change in the weather.

 

Futures Contract x Commodities

Investors can invest in commodities with the aid of a futures contract which serves as a legal contract that binds investors to buy or sell a given commodity asset at a price that has been predetermined and is expected to be bought at a certain time in the future. 

Futures contracts can be found in each category of a commodity today.

Ordinarily commercial users of said commodities along with speculative investors partake in the futures market.

The Role of Commodities on the Stock Market 

Several investors who are interested in the market pertaining to a certain commodity are likely to invest in stocks of companies that are tethered to said commodity in some manner. Take for instance those who are interested in the gold sector, stocks pertaining to companies involved in refining gold, smelting it, or dealing with gold bullion are of appeal.

What makes stocks stand out is the fact they aren’t as volatile in terms of prices when set against futures contracts. Moreover, these stocks are easier to be bought, sold, held, and tracked. Furthermore, investors and traders have the opportunity to narrow their investments to a particular sector of interest to them.

One of the benefits associated with investing in stocks as a means of entering a particular commodity’s market is that trading is more viable owing to the fact that most investors already hold a brokerage account.

On the flip side, when looking at the drawbacks of accessing a commodity market via stocks, said stocks don’t ever purely indicate the commodity prices which can be affected by a number of factors unrelated to the value of the commodity that an investor might seek to track.

ETFs, ETNs, and Commodities

Investors seeking to enter the commodities market also have the option to use exchange-traded funds (or ETFs) and exchange-traded notes (ETNs). Each of these trades in the same manner as stocks thereby allowing investors the potential to profit from the fluctuations that occur within commodity prices. These investors aren’t required to invest in futures contracts directly. This means that they aren’t required to hold any special brokerage account.

To add to the appeal of ETFs and ETNs is the fact that they don’t involve any management or redemption fees as they trade in the same manner as stocks. That being said, not all commodities are tethered to ETFs and ETNs.

Mutual Funds and Index Funds as a Means of Investing in Commodities

Although mutual funds cannot be used to directly invest in commodities, the mutual funds themselves can be invested in the stocks of companies that are associated with certain commodities including those pertaining to mining and agriculture.

Like stocks, shares of mutual funds can be influenced and affected by factors beyond the fluctuating price of a commodity such as those pertaining to the company or the broader stock market.

Conclusion

Those new to the world of investing as well as those fluent in it have a wide range of options that allow them to access commodity markets. While commodity futures contracts entitle investors to a front-row show, there exist a number of alternative means of investing that pose less of a risk and provide ample exposure to the commodities in question. That being said, commodities are understood to be risk-laden investments as a lot of uncertainty surrounds them.

FAQs

Q1. What are some traits of the commodities market?
A1. The commodities market has the following characteristics. 

Demand and supply govern its operations.
Global economic developments impact it.
Technological advances affect the commodities market.

Q2. What are the four broad categories of commodities?
A2. The four broad categories of commodities are - metals, energy, agriculture, and livestock and meat.

Q3. What are some commodity exchanges that function in India?
A3.  Some commodity exchanges that operate in India include the Multi Commodity Exchange of India Limited (or MCX), National Commodity and Derivatives Exchange Limited, and the Universal Commodity Exchange.

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