What Is a Commodity?
Definition & Examples of Commodities
A commodity is a natural resource or agricultural product that is traded in bulk. They are sold by the companies that produce them and bought by companies that use them. Along with stocks, bonds, and real estate, commodities are one of the major investment asset classes.
Learn how commodities are used and traded, as well as how to participate in the commodities market directly or indirectly.
What Are Commodities?
Commodities are raw materials or agricultural products that can be bought and sold. They are one of the major asset classes of investment.
In general, commodities are not appropriate for individual investors due to their bulk nature. However, businesses from packaged food companies to airlines rely on them.
Some examples of commodities include:
- Wheat, corn, soybeans, or other foodstuffs
- Cattle or other stock animals
- Precious metals such as gold
- Domestic and foreign currencies
- Coal, oil, and other fossil fuels
Commodities of the same grade are considered fungible, or interchangeable, with each other regardless of who produced, mined, or farmed them.
For example, if high-quality copper is produced by two mining companies, one in Colorado and one in Wyoming, it is considered fungible. To a buyer, it doesn't matter which mining company produced it as long as the same quality and purity of copper can be received.
How Commodities Work
Commodities are traded on a futures market, in which suppliers and purchasers of commodities bargain for payment of the goods and a future date on which they will be delivered.
People who trade in commodities include:
- Farmers and miners who produce commodities
- Businesses that use commodities to operate
- Investors and speculators
- Consumers and strategic users
Some examples of different commodities trades include:
- A farmer in the Midwest decides to pre-sell his corn in the futures market. He won't be bankrupted if corn prices decline between planting and when he's ready to deliver to market because he already has a contract for selling to a commodities buyer.
- An airline buys fuel at a fixed rate using a futures contract in order to avoid the market volatility of crude oil and gasoline.
- A company that owns coffee shop chains buys huge amounts of raw coffee for future use in manufacturing its branded coffee. The purchase is made at today's prices, allowing the company to stabilize its production costs.
Most commodities, but not all, trade on what is known as a commodities exchange such as the Chicago Board of Trade (CBT) or the New York Mercantile Exchange (NYMEX).
These exchanges allow commodities to be bought and sold similarly to stocks. They standardized the commodities contract when a trade is executed, establishing a fixed price and future delivery date for whatever is being traded. On the delivery date, the commodity is traded and money exchanges hands at price in the contract, regardless of the current price of the commodity.
Anyone who trades in futures or advises other investors about trading futures must be registered with the National Futures Association.
Individual commodity buyers are less common and generally trade in items like precious metals. An individual buyer might purchase large amounts of something like gold coins, then store them somewhere safe as a hedge against inflation risk.
Individual investors can also invest in commodities pools to diversify their portfolios. These are frequently organized as mutual funds or exchange-trade products (ETPs). These are different than traditional mutual funds or exchange-traded funds because you do not own a share of assets itself. Instead, you are buying the right to buy or sell an asset for a limited window of time in the future. This can be highly risky.
Do I Need Commodities?
Commodities are generally not considered good options for new or individual investors.
When you trade commodities, you are paying for the right or obligation to buy or sell the underlying future, which itself is a right or obligation to buy or sell the underlying asset, without collecting the asset. This can be confusing and risky for new investors who don't have the background to understand how prices and commodities will likely move in the future.
The funds necessary to buy and sell commodities in bulk may also be out of reach for many individual investors.
The government agency in charge of regulating commodity futures trading, the Commodity Futures Trading Commission (CFTC), cautions that investors should be wary of high-yield investment opportunities in futures, including options or foreign exchange (forex). These are frequent areas of fraud.
More experienced investors who understand both the commodities market and the needs of companies that use that commodity may have more success in trading these assets while managing the risks involved.
Alternatives to Commodities
There are many asset classes you can invest in other than commodities, including:
- Mutual funds
- Exchange-traded funds (ETFs)
- Real estate
- Real estate investment trusts (REITs)
You can also get indirect exposure to commodities by investing in stocks, mutual funds, or exchange-traded funds that work with specific products or materials. Rather than investing in a commodity directly, you could invest in:
- A mutual fund that includes that commodity
- Shares of a company that produces that commodity
Taking this approach is generally less risky and easier to understand for the average investor.
- Commodities, one of the major investment classes, are raw materials or agricultural products that can be bought and sold.
- Commodities are traded on a futures market, in which suppliers and purchasers of commodities bargain for payment of the goods to be delivered on a future date.
- On the delivery date, the commodity is traded at the price in the contract, regardless of the current price of the commodity.
- Businesses from packaged food companies to airlines rely on them.
- Commodities generally are not appropriate for individual investors due to their bulk nature.