What Is a Commodity?

Definition & Examples of Commodities

Woman on a farm feeding calves

 Getty Images / Peter Cade

A commodity is a product that is traded in bulk. These products can be a natural resource or agricultural product.

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 more about how commodities are used and traded. Then, find out how you can be part of the commodities market.

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 a good choice for individual investors due to their bulk nature. Many businesses, though, rely on them. They are vital for industries from packaged food to airlines.

Some kinds of commodities are:

  • Wheat, corn, soybeans, or other bulk foods
  • Cattle or other livestock
  • Cotton
  • Lumber
  • Sugar
  • Precious metals such as gold
  • Domestic and foreign currencies
  • Coal, oil, and other fossil fuels

Commodities of the same grade are known as fungible. This means they can be swapped with each other no matter who produced, mined, or farmed them.

For example, if high-quality copper is produced from two mines, one in Colorado and one in Wyoming, it is fungible. To a buyer, it doesn't matter which mine produced it. What matters is that the same quality and purity of copper can be received.

How Commodities Work

Commodities are traded on a futures market. In this market, the people who produce goods and the people who buy them bargain for payment. These contracts also set a future date on which the goods will be delivered.

People who trade in commodities can be:

  • Farmers and miners who produce goods
  • Businesses that buy or use goods
  • Investors and speculators
  • Consumers and strategic users

There are many examples of commodities trades.

A farmer in the Midwest may decide to pre-sell his corn in the futures market. He gets a contract for selling to a buyer at a set price on a set date. That way, he won't be bankrupted if corn prices decline between planting and when he's ready to send his corn to market.

Or, an airline may buy fuel at a fixed rate using a futures contract. This allows the airline to avoid surprise changes in the prices of crude oil and gasoline.

A company that owns coffee shop chains might buy huge amounts of raw coffee. This can be used in the future to make its branded coffee. The purchase is made at today's prices, which means that the cost of making the branded coffee will be more stable.

Most commodities, but not all, trade on what is known as a commodities exchange. Two common ones are the Chicago Board of Trade (CBT) and the New York Mercantile Exchange (NYMEX).

These exchanges allow commodities to be bought and sold in the same way that stocks are. They create a standard contract for when a trade will happen. This creates a fixed price and future delivery date for the good that is being traded.

On that date, the commodity is traded and money exchanges hands. The price at this time is the one in the contract, no matter what the current price of the commodity on the open market is.

Any person who trades in futures or advises others about trading futures must be registered with the National Futures Association.

Individual commodity buyers are less common. They often trade in items like precious metals.

For example, a buyer might purchase large amounts of gold coins. Then, the buyer would store them in a safe place as a hedge against inflation risk.

Individual investors can also invest in commodities pools. This is a way to diversify the assets you hold. These pools are often structured as mutual funds or exchange-traded products (ETPs).

These are different than traditional mutual funds or exchange-traded funds. You do not own a share of the assets themselves. Instead, you are buying the right to buy or sell an asset for a short window of time in the future. This can be very risky.

Do I Need Commodities?

Commodities are most likely not a good option for you if you are a new or individual investor.

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 buyers who don't have the background to know how prices and goods may move in the future. The funds you need to buy and sell commodities in bulk may also be out of reach.

The government body in charge of regulating these trades, the Commodity Futures Trading Commission (CFTC), cautions that investors should be wary of high-yield investment opportunities in futures. This includes foreign exchange (forex) options. These are often areas of fraud.

More experienced investors know both the futures market and the needs of companies that use a given good. As a result, they may have more success trading these assets in spite of the risks involved.

Alternatives to Commodities

There are many asset classes you can invest in other than commodities. These include:

There are stocks, mutual funds, or exchange-traded funds that work with specific products or goods. You can get exposure to commodities by investing in these assets. Rather than investing in a commodity directly, you could invest in:

  • A mutual fund that includes that commodity
  • Shares of a company that farms or mines that good

Taking this approach is often less risky for the average investor.

Key Takeaways

  • 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 buyers 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, no matter what the current price of the good is.
  • Businesses from packaged food companies to airlines rely on them.
  • Commodities often are not a good choice for individual or new investors.