A commodity is any physical product whose prices are subject to supply and demand. A commodity is a basic good where the quality of the product won’t differ depending on where it’s sourced. For example, a barrel of oil will be placed on a commodity market at the same place, no matter where in the world it’s from. Commodities are usually traded with futures contract.
What are Commodities?
Commodities have been used in everyday life for centuries. Whether you buy rice for lunch or gasoline to drive to your workplace, you are taking part in the commodities markets on a regular basis. Besides being used in everyday activities, commodities are also actively traded on the financial market through stocks and futures, and traders can even speculate on their price without any actual physical delivery taking place.
In this article, we’ll cover what commodities in finance are, how they’re grouped and how to trade them.
What are Commodities in Finance?
Commodities are an important asset class in financial markets, as they provide the ability to diversify one’s portfolio and boost total returns. Some commodities can be extremely volatile, such as energy products and food, and countries exclude them when calculating the increase in core consumer prices (also called Core CPI). However, commodities usually tend to move in the opposite direction of the stock market, making them a welcoming diversification investment.
Some commodities, such as precious metals, are considered as safe-havens in times of political and economic turmoil in other financial markets. A typical example of a safe-haven is gold, as gold prices tend to rise when risk appetite in the market deteriorates.
Types of Commodities
In general, commodities can be grouped into metals, energy, livestock and meat and agricultural commodities. Agricultural commodities and livestock are also referred to as soft commodities, while commodities that need to be mined are also called hard commodities.
- Metal commodities include: gold, silver, other precious metals, copper, iron
- Energy commodities examples: Brent crude oil, WTI, heating oil, natural gas
- Livestock and meat: live cattle, feeder cattle, pork bellies, lean hogs
- Agricultural commodities: soybeans, wheat, corn, rise, cocoa, coffee, sugar, cotton
To trade these commodities, investors are usually buying commodity futures contracts on the futures market, which are used to buy or sell a commodity at a set price at a later time. Nevertheless, most of the traded futures contracts are cancelled before expiry, meaning that in most cases no physical delivery takes place. Farmers are also using the futures market to lock the price of a certain commodity that they’re producing, preventing losses if the price of the commodity falls.
Commodities are traded on commodity exchanges, which can specialise in a single group of commodities or carry a few different commodities. One of the most popular exchanges in Europe is the London Metal Exchange, which specialises only in metal commodities.
In the United States, popular exchanges include the Chicago Mercantile Exchange and Chicago Board of Trade which merged in 2006 and the Intercontinental Exchange in Atlanta. These exchanges trade only regulated commodities by the Commodity Futures Trading Commission.
Retail traders can also trade CFDs on commodities. Contracts for Difference (CFDs) track the price of the underlying instrument, and the trader makes a profit if the commodity price rises, or a loss if the price falls.
There are certain trading rules which can come in handy to retail traders. The price of gold is usually inversely correlated to the US dollar index, which means that when the US dollar appreciates, gold usually falls, and vice versa. Most of the world’s gold is denominated in US dollars, and a rising dollar causes gold in foreign markets to fall in value.
Forex traders also need to be aware of the relationship between commodities and currencies of countries which are major commodity producers. These currencies are also called commodity-pegged currencies, and include the Canadian dollar, the Australian dollar and the Russian ruble, to name a few.
Canada is a major oil exporter, and rising oil prices tend to have a positive effect on the Canadian dollar. Australia, on the other hand, is an important exporter of metals and raw materials, which makes the Australian dollar heavily influenced by changes in the price of those commodities.
When all is said and done, commodity trading is important
Commodities are an important asset class in financial markets, used to diversify an investor’s portfolio and boost its performance. They are mostly traded in the form of futures contracts, but retail traders can also trade on CFDs. Since many currencies are related to the price of commodities, Forex traders need to be aware of these correlations to make the most out of their trading.