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What is a commodity? How to Profit with Trading

Petra HessPetra Hess ·

image of commodities

Did you know that you can profit off the price of oil, gold or even corn? These are all examples of commodities. There is a whole market for commodities with many ways to trade and invest in them.

Commodities are a lesser known choice for investment. Partly due to the fact that simply not as many people know what they are or how to invest in them. However, the commodities market is crucial to the global economy as it encompasses the food we eat and the raw materials used to make consumer goods.

There are a number of ways to define a commodity. One way would be to describe a commodity as an interchangeable good or material which can be bought and sold freely as an article of commerce. They must be interchangeable so the dealers are all offering the same product and buyers know what they are getting without having to actually inspect each one.

Some of the major groups of commodities are:

  • agricultural
  • energy
  • metals

Agricultural commodities include things such as corn, rice, soybeans, sugar, and cocoa. Also included under the agricultural description would be livestock such as cattle and hogs.

Listed energy commodities include oil, natural gas, gasoline, and propane. While, metals include copper, tin, aluminum, gold, silver, and palladium among others.

image of commodities

Photo credit: UBC Commodities

Raw Materials = Commodities

Raw materials are used to make the finished goods sitting on the shelves of stores. Finished goods such as shoes, clothing, and appliances are all manufactured with the use of commodities. The finished goods are the end products on the shelves.

Value can be added through branding and marketing to differentiate them from other products in the same category.

For example, Nike vs. Puma shoes. They are both shoes and use many of the same raw materials purchased through the commodities market. However, consumers are willing to pay a different price for each.

This is a result of differentiation through the manufacturing process and the use of branding and marketing. A company can add different values to the products, as opposed to commodities which are all generally the same. Therefore priced the same.

Nike lebron and puma Clyde

Credit: Nike website and Puma website

Commodity Exchanges

Commodity trading dates all the way back to the 17th century in Japan with the first recorded trades being in rice. There is also evidence to suggest that rice futures were traded in China 6000 years ago.

Commodity futures trading in the US began in the mid 1800s with the formation of the Chicago Board of Trade (CBOT) in 1848. Other major exchanges in the US today are the Chicago Mercantile Exchange (CME), the New York Mercantile Exchange (NYMEX), and the New York Commodity Exchange (COMEX). All owned and operated by the CME Group.

Globally, there are futures trading exchanges in over twenty countries. The major exchanges being located in the US, Australia, Canada, England, France, Singapore, Japan, and New Zealand.

A commodity exchange is organized under established rules and regulations and used for the purchase and sale of commodities. The Commodity Exchange Act (CEA), passed in 1936, regulates the trading of futures in the US. The Commodity Futures Trading Commission (CFTC) operates under the framework established by the CEA.

Commodities used to be traded at a physical exchange by traders in what was known as a trading pit, as seen below. With technological advances, commodity exchanges have moved to electronic trading.

Commodity Market Economics

Because commodities are uniform, their prices are affected by the pure economic force of supply and demand. A free market is driven not by producers, but by consumers. Ultimately the market value for any good or service is determined by its value to the consumer. All else equal, higher demand will result in a higher price.

As prices rise, producers will have higher profits. These profits will result in the means to expand production increasing the supply. If the supply increases too much, it could result in lower prices if the demand for the product doesn’t change.

There is an equilibrium price for the exchange of goods that occurs when buyers and sellers agree on a price. This is where supply and demand are in balance. These balances are ever changing as suppliers produce more at higher prices and consumers buy less at higher prices. Price will change based on these forces.

supply demand curve

Unpredictable factors such as weather can affect the supply in the agricultural commodities market. This creates a risk when trying to run a business. Good weather can result in a higher supply. If demand stays the same, the sellers will have to lower prices to get rid of the inventories.

Growth in manufacturing economies can increase demands of raw materials like steel and oil causing those prices to increase if supply stays the same. Technology changes  can increase demand for raw materials like steel and palladium. At the same time technology can increase supply in agricultural commodities by increasing production and lowering prices if demand doesn’t change.

Investing and Trading Commodities

Futures, options, stocks, and ETFs are some of the ways to invest in commodities. Some players in the market are the farmers and mining companies producing them. Another player would be the manufacturers buying commodities to create finished goods. As well as the speculators hoping to buy and sell for a profit based on their knowledge and expectations of prices in the short term.

Businesses may use commodity futures to navigate risk and uncertainty. Budgets and earnings projections can be affected by fluctuations in the prices of the raw materials used to make their products. For this reason they use commodity futures to guarantee a supply at a certain price.

By doing so they can manage the risk associated with potential price swings. Mostly due to fluctuations in supply and demand. The producers of commodities also transfer the risk of price swings by using the same futures contracts.

Speculators buy and sell to make profits on the price swings. They may study weather patterns, economic growth, growth in specific sectors, or specific products to uncover demand changes.

They may also research the manufacturers as a way of estimating supply changes. With this knowledge, they make decisions and place their trades.

 

commodity

Individual Investment

You can also participate in the commodities market. One way is to use ETFs to hold investments over a longer time frame. With this there isn’t the risk of high leverage or short term price swings bankrupting your account.

You can buy the SPDR Gold Trust (GLD) if you want to invest in gold. United State Oil Fund (USO) if you feel oil prices will be rising. If you think gas prices are going up for the summer months or will continue up for years due to expansion in gas consuming industries, you might buy United States Gasoline Fund (UGA).

Another way for you to take part in the market is buying individual stocks of the companies that produce commodities. While this is not a pure play as you aren’t buying the commodity directly. You are investing in a company that produces it, therefore getting some exposure.

Examples of stocks:

Gold:

  • Gold Newmont Goldcorp (NEM)
  • Barrick Gold Corp (ABX)

Steel:

  • Nucor Corporation (NUE)
  • United States Steel (X)

 

steel plant

Oil and Gas:

  • Diamond Offshore Drilling Inc (DO)
  • Transocean LTD (RIG)
  • Exxon Mobil (XOM)
  • ConocoPhillips (COP)

Agricultural, meat:

  • Tyson Foods (TSN)

Final Thoughts

Commodities are the basic inputs for consumer goods and food. Trading has created a major global market based on supply and demand. It can be used to hedge positions as a manufacturing company may do. Trade for short term price swings as a speculator may do. Invest for longer appreciation as an individual investor may do. Or as a way to simply buy fruits and vegetables sold in grocery stores.

Commodities are essential and will always be essential to our lives. The more you know about them, the better you will be able see the potential long term price trends that can come from consumer spending trends and changes.

With gold stocks being hot, as well as oil and other commodities in play… I’ll be closely watching the sector. These stocks are some that are on my radar… and I may look to get into any one of these stocks if my indicators give me the green light. If you’re interested in learning how to easily time your entries and exits and generate consistent returns… then watch my latest trading lesson.

commodity

 

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