Trading commodities is a high-risk, high-reward endeavor. Here's what you should know before you get started.
Commodity goods are raw materials, like corn, flour, oil, and metals. Commodities trading is the buying and selling of these raw materials. Sometimes it involves the physical trading of goods. But more often it happens through futures contracts, where you agree to buy or sell a commodity for a certain price at a specified date.
Commodities can add diversification to your portfolio and provide an inflation hedge. However, commodities are highly volatile. Trading commodities is complex because factors like weather events and political strife that are often difficult to predict can have an outsize impact on prices. Keep reading to learn the basics of how commodities trading works and some alternative ways to invest in commodities.
What is commodities trading?
When you buy an ear of corn or a bag of wheat flour at a supermarket, you probably don't pay much attention to where they were grown or milled. That's because both corn and flour are commodities. Commodities trading is the buying and selling of these interchangeable materials in bulk. Often these raw materials are the building blocks of manufactured products.
Commodities traders bet on how the commodity's price will move. If you think the price of a commodity will go up, you buy futures, or go long. If you think the price will drop, you sell futures, or go short.
Although it's possible to trade commodities by buying and selling the physical commodity, trading through futures contracts is far more common. These agreements specify the terms of delivery of an asset for a specified date in the future. They're often used by producers or major industrial consumers as a risk management tool in case prices increase or decrease.
How to invest in commodities
Commodity trading isn't the only way to invest in commodities. Here are four basic ways.
1. Invest directly in the commodity
The most straightforward way to invest in commodities is by physically buying a commodity. One advantage is that you don't have to go through a third party. Typically you can do a simple internet search to find a dealer to sell you a particular good. When you no longer want it, that dealer will often buy it back. But you have to figure out delivery and storage logistics.
If you're buying gold, this may be relatively simple. You can easily find a coin dealer online who can sell you a bar or coin. You can safely store it and later sell it as you wish. But it gets a lot harder when you're trying to figure out delivery and storage of cattle, crude oil, or agricultural commodities, like bushels of corn. For that reason, investing in most physical commodities typically takes too much effort for individual investors.
2. Invest in futures contracts
You can trade commodity derivatives, such as futures contracts, as long as you have a brokerage account that allows for it. But futures contracts are largely designed for major companies involved in commodities rather than for individuals.
When you trade futures, you'll be required to maintain a certain amount of capital, known as margin, in your brokerage account. One risk of trading commodities is that the margin requirements are often lower than for stocks. When you trade on margin, you're trading borrowed money, which can amplify your losses. Given the volatility of commodity prices, it's essential to have enough resources on hand to cover any margin call, which is when your broker requires you to deposit more money.
3. Invest in commodity stocks
Another way to invest in commodities is to buy shares of the companies that produce them. For example, you could buy metal stocks, energy stocks, or meat stocks.
A commodity-producing company won't necessarily rise or fall in line with the commodity it produces. Sure, an oil production company will benefit when crude oil prices rise and suffer when they fall. But far more important is how much oil it has in its reserves and whether it has lucrative supply contracts with high-demand purchasers.
4. Invest in commodity ETFs and mutual funds
Commodity exchange-traded funds (ETFs) and mutual funds offer commodity exposure for those who don't want to buy the commodity directly. You can find an investment fund that invests in physical materials, commodity stocks, futures contracts, or a combination.