- Commodities are publicly traded tangible assets, agricultural products, and natural resources used in commerce and trade.
- Though highly volatile and high-risk, commodities can serve as a counterweight to stocks and bonds and a hedge against inflation.
- Investors can own commodities outright, but most buy commodity-related stocks or funds, or options on commodities futures contracts.
When you think about investing, stocks and bonds are probably the first things that come to mind. But you can also invest in tangible goods and substances. Known in the financial world as commodities, they're often made up of the things you use or consume every day — from foodstuffs to gasoline to metals.
Definition and overview of commodities
What is a commodity?
Commodities are publicly traded tangible assets. Some great examples of commodities are oil and copper, which are used in the production of many different consumer goods, as well as grain, used as a component to create a wide range of foods.
Commodities are one of the oldest ways to invest, far predating stocks and bonds. In fact, the strength of many civilizations and countries has been linked to the buying and selling of commodities. The spice trade shaped the modern world in a lot of ways. The animals, textiles, and jewels moving along the Silk Road to market forged ties between Europe and Asia. The Vikings set sail to lands in search of grains and livestock.
Commodities have financed societies and helped them grow. The ancient Greeks and Romans used gold as a currency. Hundreds of years later, in the 19th century, the U.S. Gold Rush more than tripled the population of California.
Today, commodities are considered alternative investments, while paper assets are considered traditional ones. Still, they can play a key part in your portfolio.
"Commodities tend to have a low to negative correlation to stocks and bonds" — that is, their prices generally move in the opposite direction from these securities, explains Trina Patel, director of operations at Albert, a savings and investing app.
For this reason, many investors turn toward commodities when the stock market has a poor outlook, or just to diversify their holdings.
Here's what you need to know about commodities, how they work, and how to invest in them.
Characteristics of commodities
Many commodities are natural resources — for example, industrial metals like copper, silver, and gold. Oil and natural gas, which are sources of energy, are other examples of commodities.
Commodities are frequently used to make other goods. Metals like copper, for example, are used to make a wide range of goods, including cars and electronics. Oil is involved in the manufacture of a wide range of consumer goods.
Types of commodities
Agricultural commodities
One subset of commodities is agricultural commodities. These raw materials are sometimes described as soft commodities. This includes crops, with some of the most popular being corn, soybean, wheat, sugar, and coffee.
Overall, these commodities are subject to weather, natural disasters, and disease, but can be profitable in the face of population growth and limited food supply.
Energy commodities
Another subset of commodities is the energy commodities sector, which includes oil, natural gas, coal, and natural liquids. These are used as energy sources and have a wide range of industrial and consumer applications.
These include crude oil, heating oil, gasoline, and natural gas. As there is a limited global supply, energy prices have historically increased with demand. Energy commodities are volatile, affected by everything from economic ups and downs to regulations from the Organization of the Petroleum Exporting Countries (OPEC) and the shift toward renewable energy sources.
Metals
This includes both industrial metals and precious metals. Industrial metals are used to make other items, for example a wide range of consumer goods, while precious metals derive their price from their value as speculative assets.
Gold is one of the most popular metal commodities because of its long history as something of value. Many investors choose to invest in gold and other precious metals when stock prices are falling. Other metal commodities include silver, platinum, aluminum, tin, and copper.
Examples of common commodities
Gold
Gold is a precious metal that has long been recognized for its value. The commodity has been used as a currency at many different points in history. It is also used by people the world over for jewelry.
Oil
Oil is a raw material that is used as an energy source by economies all over the world. The price of oil has repeatedly generated widespread visibility, as it can have a significant impact on economies. If oil prices become too high, it can constrain growth by reducing consumer spending.
At the same time, hydraulic fracturing (fracking) was credited with helping create a large number of jobs in the U.S. at some points.
Wheat
Wheat is used to create many different kinds of food including bread, pizza, and pastries. Roughly 75% of all U.S. grain products are created using wheat flour. The price of wheat can be highly volatile. It is at the mercy of factors like geopolitical conflict.
Natural gas
Natural gas has many different applications, including generating electricity. It is used to heat buildings, and it is also used in air conditioners. A major variable affecting the demand for natural gas is the temperature. This demand reaches its highest point during the winter months, which can place upward pressure on prices.
How commodity markets work
Commodity exchanges
Like stocks, commodities trade on public exchanges, their fluctuating prices posted openly. Exchanges either specialize in a particular group of commodities or offer several different types of commodities. For example, the London Metal Exchange (LME) specializes in metals, while the Chicago Mercantile Exchange (CME) offers trading of agriculture, energy, and metals.
Futures contracts
One way investors can trade commodities is through futures, which are derivatives contracts that obligate two parties to make a specific exchange at a predetermined time for a set price.
These contracts are mostly used by institutional investors, for example hedge funds. However, many different organizations, including manufacturers, trade futures contracts in order to manage risk. Some examples of commodity futures contracts are 90-day gold and 90-day oil.
Investors who want to trade these derivatives contracts will usually need to open special accounts with futures commission merchants to do so.
Spot markets
Spot markets offer various assets for immediate delivery, including a wide range of commodities. Basically, investors pay cash to receive a certain amount of a commodity right here and now. Interested parties can buy a wide range of raw materials in this manner.
Investing in commodities
Direct investment
One of the simplest ways to invest in commodities is to buy them directly. You don't need to use a third party, and you can easily find a dealer, purchase what you want, and re-sell it when you don't. However, this approach doesn't work with every type of commodity.
Dealing with a precious metal like gold can be relatively simple since it's among the more liquid commodities, available in coins, bullion, jewelry, and bars. Direct ownership is a lot more complicated with large quantities of heavy — or living — things like cattle, crops, and drums of oil. When you get into the logistics of storage and shipping, it will be unmanageable for most people.
Commodity ETFs and mutual funds
One easy way for investors to get involved with commodities is by purchasing exchange-traded funds (ETFs) or mutual funds that grant exposure to these raw materials. Buying a share of an ETF or a mutual fund is as easy as opening up a brokerage account, funding it, conducting your due diligence, and making a purchase.
ETFs trade like stocks, so you can buy and sell them during regular trading hours. You can also take short positions on these funds.
Commodity stocks
Another way you can gain exposure to commodities, albeit indirectly, is through shares of companies involved with these raw materials. A perfect example is companies involved in mining such materials, for example businesses involved in extracting gold, silver, and other metals.
Some very large companies, for example ExxonMobil, are involved with energy commodities like oil and gas. Some of these larger energy companies may offer investors compelling dividends.
Risks and rewards of commodity investment
Commodities can be highly volatile since they are at the mercy of many different variables like weather events, natural disasters, and policy changes. However, they can also prove helpful in achieving diversification, as their prices often don't move in the same direction as more traditional assets like stocks and bonds.
These raw materials can also prove useful as an inflation hedge. When the price level increases, commodity values frequently rise right along with it.
Commodity FAQs
What is a commodity?
Commodities are publicly traded tangible assets, agricultural products, and natural resources used in commerce and trade.
What are the main types of commodities?
The main types of commodities are agricultural commodities, energy commodities, metals, and livestock and meat.
How can I invest in commodities?
You can invest in commodities in many different ways. You can invest in them directly, you can purchase commodity ETFs and mutual funds, or you can buy commodity stocks.
What are the risks of investing in commodities?
Commodities can be highly volatile. Past that, their prices are vulnerable to a wide range of outside factors, for example weather events, natural disasters, trade embargoes, and geopolitical conflict.
What is a futures contract?
Futures are derivatives contracts that obligate two parties to make a specific exchange at a predetermined time for a set price.
