What is a Commodity?

Commodities are like ingredients in a recipe…

The food that comes out of the oven is the final product. But you can’t just make cookies out of thin air. You need eggs, flour, milk, sugar, and all the other things that you combine to create something tastier. The economy functions the same way. It requires copper, oil, steel, iron, and all the other things (collectively called commodities) that turn into added-value products.

The most traded commodities in the world include:

• Crude oil
• Steel
• Soybeans
• Iron
• Corn
• Gold
• Copper
• Aluminum
• Silver

Commodity markets can be generally broken down into two classes:

These are mostly food-related products, which have a shelf life. They are typically grown rather than mined. Once they get used, they cannot be used again. These are also renewable products, meaning they can be replaced. Soft commodities include:

• Coffee
• Corn
• Wheat
• Barley
• Soybeans
• Sugar
• Timber
• Cotton
• Pork

Hard commodities are things that can last forever. Because they are non-perishable, it’s possible to stock up on these materials until prices rise. Hard commodities are mined and include things like:

• Gold
• Silver
• Copper
• Tin
• Zinc
• Rubber
• Rare earth minerals

Hard commodities are non-renewable, meaning there is only a finite amount of each of these products. Having a finite amount of something creates scarcity, which makes pricing these commodities different from soft commodities. These materials are also durable –- They can generally be reused, recycled, and repurposed.

Another commodity group worth noting falls between these definitions. Energy products are non-renewable like a hard commodity but are consumed when used. They include things like:

• Oil
• Natural gas
• Coal
• Biofuel

Commodities are the raw materials used to make products. Products are finished goods — like many of the things people buy at the store. Many companies are in the business of turning commodities into products.

One key difference between a commodity and a product is fungibility. Commodities are generally all the same, at least within the same grade. For example, there are no defining characteristics that differentiate Iowa corn from Kansas corn –- It’s all just corn. The commodity exchange sets an expected quality level for a contract, which is called a basis grade, to account for differences in quality. But the commodity is not differentiated based on branding.

Products, on the other hand, can have different prices based solely on the brand selling them. Products are usually differentiated in other ways too. For instance, cornmeal is not the same as corn tortillas. Products do not sell for the same price, cannot be directly substituted for one another, and are differentiated through branding and advertising.

There are a few ways to trade commodities:

The most straightforward way to trade in commodities is to buy or sell them directly. That could mean buying gold from a dealer or corn from a farmer. Some people stock up on commodities and sell them when the price goes up.

Most commodity trading occurs on exchanges. One of the world’s oldest modern commodity exchanges is the Chicago Board of Trade, founded in 1848. This exchange standardized contract terms and improved the efficiency of the commodity market. It’s now part of the Chicago Mercantile Exchange and is a prominent marketplace for a variety of commodities. The New York Mercantile Exchange is another marketplace that trades primarily in energy and metal commodities. Internationally, notable marketplaces include the London Metals Exchange, the Australian Securities Exchange, and the Tokyo Commodity Exchange.

Unlike trading in stocks, trading commodities does not involve buying and selling ownership in a company. Instead, you are purchasing a contract for the delivery of physical materials in the future (known as a futures contract). Companies that produce commodities offer them for sale, usually at a future date. That makes them the sellers, or suppliers, in the commodity market. Companies that use commodities to create the products they sell make up the real buyers that want delivery.

A lot of traders are not interested in actually getting those commodities delivered. They purchase the contract with the intent to sell it before the delivery date. This is based on their belief that the price of the commodity will increase before then. So the price of futures contracts points to the price of the derivative asset (the underlying commodity for future delivery). People engaged in this type of trading are guessing which direction the price will go. As such, they are known as speculators.

Sometimes futures contracts are referred to as paper assets (a crude oil contract might be called paper barrels of oil). In this way, the volume of trade can exceed the actual physical quantity of the commodity (as each unit can be traded several times before delivery).

Other traders don’t purchase futures contracts directly. Instead, they purchase an option allowing (but not requiring) them to buy (or sell) a commodity futures contract at a specific price by a certain date. If the commodity is trading at a better price than the option, the trader can choose to let the option expire.

Going “long” means you think the price of a commodity is going to rise. Say you buy a call option to purchase 1,000 barrels of oil for $70 per barrel within 12 months. If the price of oil goes above $70 per barrel anytime before the option expires, you could exercise the option at $70 and get a delivery contract in place of the option. If you want, you can immediately sell the futures contract for a potential gain, which is called cash settlement.

The same idea can work in the other direction, which is called going “short.” In that case, the seller has the obligation to sell those barrels (through a futures contract) at a certain price. If you were right, and prices fall, you just have to buy the future contract at the lower price and then sell it at the option price.

Commodity markets offer a great deal of leverage (ability to enter contracts with borrowed money) to traders. Because speculators rarely take physical possession of the commodity they are trading, the net exchange of cash is usually far less than the face value of the contract. For example, if you purchase a contract for $100,000 and then sell it a week later for a gain or loss of 10 percent, then only $10,000 ever really changes hands. Exchanges and brokers often allow traders to purchase a contract of far greater value than the trader has on hand. Of course, the contracts the trader buys acts as collateral (something of value that the lender gets to keep in case of default).

Alternatively, you can gain exposure to commodities through the stock market. You can purchase common stock in a company that conducts business with the commodity of interest (like gold mining or oil companies).

You can invest in a suite of companies doing business in your favored industry by purchasing shares of an exchange-traded fund (ETF). An ETF is a fund that holds ownership in many different companies doing business in the sector of choice. For example, an oil ETF might include shares of large extraction companies, support companies, and smaller independent companies. Buying into an ETF tends to smooth out differences in company performance, leaving changes in the commodity’s value as a larger reason for movements in the fund’s value. It also allows investors to diversify their holdings, reducing the risks associated with concentrating investments into fewer firms.

Keep in mind, trading in commodities, futures, and options involves significant risk and isn’t appropriate for all investors — You can lose your entire investment.

To learn more about the risks associated with options trading, please review the options disclosure document entitled Characteristics and Risks of Standardized Options, available here or through https://www.theocc.com.

Investors should absolutely consider their investment objectives and risks carefully before trading commodity, futures and options.

The above examples are intended for illustrative purposes only and do not reflect the performance of any investment.

Diversification strategies do not ensure a profit and cannot protect against losses in a declining market.