What Are Commodities and How Do You Trade Them?

You can invest in everything from soybeans to cattle

A vast field of corn
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If you have ever wondered what a commodity is, rest assured you are not the only one that has asked. Commodities, along with stocks, bonds, real estate, and other assets, form one of the major investment asset classes. Though they are largely not appropriate for individual investors due to their bulk nature, everyone from packaged food companies to airlines rely on them to conduct business.

Commodities are natural resources and foods that come from the earth. Some examples of these goods are wheat, cattle, soybeans, corn, oranges, various metals, coal, cotton, and oil. Commodities of the same grade are considered fungible—that is, interchangeable with other commodities of the same grade regardless of who produced or farmed it.

Commodities Explained

An example of a fungible could be high-quality copper produced by a mining company in Colorado, and a different mining company in Wyoming which also produces high-quality copper. If the copper produced by both mining companies receive the same grade or purity, it is considered fungible. As a buyer of high-quality copper, it doesn't matter which mining company produced it as long as the same quality of copper can be received.

Who Trades Commodities and Why

The futures market is one in which suppliers and purchasers of commodities bargain for delivery and payment of the goods to be delivered on a future date. Farmers, miners, investors, speculators, consumers, and strategic users buy and sell commodities for a variety of reasons.

For some examples, a farmer in the Midwest may want to pre-sell his corn in the futures market. He'll know he won't be bankrupted if corn prices decline between planting and when he's ready to deliver to market (because commodity suppliers and buyers create contracts to buy and sell the commodities).

An airline might buy fuel at a fixed rate using a futures contract in order to avoid the market volatility of crude oil and gasoline.

A company like Kraft Heinz might buy huge amounts of raw coffee for future use in the manufacturing of its Maxwell House coffee brand at today's prices, allowing the company to monitor and measure its upcoming production costs.

How Commodities Are Traded

Most commodities, but not all, trade on what is known as a commodities exchange such as the Chicago Board of Trade (CBOT) or the New York Mercantile Exchange (NYMEX). In this way, you can buy and sell commodities similarly to stocks.

You can also buy commodities directly. For example, you might purchase Canadian gold maple leaf coins and store them somewhere safe as a hedge against inflation risk.

There are also ways to get indirect exposure to commodities by investing in stocks, mutual funds, or exchange-traded funds that work with specific products or materials. For example, if you don't want to buy gold directly, you can buy an ETF managed by people who buy gold bullion. Or you could buy shares of a company that mines gold. Taking this approach is generally less risky and easier to understand for the average investor.

Commodity Exchanges and How They Work

Imagine you wanted to buy 30,000 bushels of corn for a cornbread company you own. While you can knock on doors and talk to farmers, it might be easier to use a commodities broker to bid for them. The NYMEX standardizes the commodity contract.

Each contract must be made up of 5,000 bushels of corn, or 127 metric tons. The contract price is quoted in cents per bushel. Listed contracts can represent physical delivery in March, May, July, September, or December.

Once the contracted delivery date is reached, delivery of the commodity is made and money exchanges hands, at the contracted price, regardless of the current price of the commodity.

Commodity Options

If you are a new investor, it might be best to stay away from commodity options until you're more familiar with trading. Still, if you want to know what a commodity option is, the simple explanation is that it is a financial instrument based on the value of a futures contract.

This financial security is derived from the commodity it is based on. The security is then traded. Another security is created, deriving from the value of the first security derivative—then it is traded.

This is why commodities futures options can be dangerous for new investors—securities derived from securities that were derived from the underlying asset, the commodity, cause confusion.

You are gaining a sort of super-leverage (large debt to fund the investment), paying for the right or obligation to buy or sell the underlying future (the security), which itself is a right or obligation to buy or sell the underlying asset, without collecting the asset.