What are Commodities?

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Most people use or consume commodities on a daily basis, yet when it comes to investments they ask - what are commodities?

The simplest answer to the question is that commodities are the raw ingredients or components of almost everything we consume or use in our everyday life. Some of the most common commodities are corn, wheat, gold, silver, copper, oil, gas, cattle, sugar, coffee, and cotton.

Many commodities are produced around the world by many countries.

However, some commodities are mainly produced in limited regions of the world where they exist in the crust of the earth or the soil is appropriate for growing many of the food staples we consume every day. The U.S., China, Russia, India, and Brazil are major producers of a wide variety of commodities.

Weather can play a large part in the production of many commodities, especially agriculture commodities. Floods and droughts can have a large impact on the production of crops in any given year. The price of commodities also plays a large part in the production of commodities. More commodities tend to get produced when the prices are higher. Conversely, consumers tend to consume less of the commodity the higher the price.

Commodities for Consumers

As you might have guessed, most commodities are either grown as crops in the ground or extracted from the earth. Once grown or extracted, commodities are usually processed in some for to produce end products for consumers.

Some examples of food products might include wheat being used to produce bread. Oranges in Florida are used to produce orange juice. Sugarcane is processed to produce table sugar. Coffee beans are harvested and eventually roasted to produce coffee. Basically, everything you see at your breakfast table is a commodity.

There are also commodities that are used for industrial and manufacturing purposes. For example, copper is used to produce wiring for homes and automobiles. Cotton is used in the textile industry to produce clothing. Crude oil is a commodity that is sent to a refinery to produce unleaded gas and heating oil – both of which are also commodities.

Commodities for Investors

Once you can easily spot a commodity, you might be looking for a way to invest in commodities. The same way you can identify companies to invest in through publicly traded companies, you can just as easily invest in specific commodities. The movie Trading Places in the early 1980s was probably the best promotional advertisement for the commodity markets. Eddie Murphy broke commodity trading down into simplistic terms. The film was an oversimplification and the profits rarely come easily in the real world.

Commodities are traded in the form of futures contracts on a futures exchange or ETN and ETN products that trade on equity exchanges. The two largest futures exchanges in the U.S. are the CME Group and ICE Futures. Futures contracts are leveraged investment vehicles and can be very volatile. They are probably not suitable for the average investor and especially for those on a shoestring budget.

One should do their homework and practice trading on a simulated platform before trading real money in the commodities markets.

For those who don’t want to invest the time but still want to trade in the world of commodities, a Commodity Trading Advisor or CTA is advisable. These are professional commodity traders who manage accounts for clients. Some trade individual accounts and other pool money from a group of investors. Your odds of success are probably better with a CTA than approaching the market as a novice.

More mainstream investments in the world of commodities are commodity stocks and commodity ETFs.

Commodity stocks are the many publicly traded companies that manufacture and produce commodities. They tend to benefit from rising prices of commodities and there is an opportunity to profit from buying commodity related stocks during bull market periods. Oil companies are a good example. Oil drilling companies, or oil producers, tend to make more money when the price is $100 than $80 oil as long as demand remains steady.

Commodity ETFs and ETNs are exchange-traded funds that invest in commodity futures or other related instruments that seek to replicate the price action in the underlying commodity. They can be leveraged or unleveraged. The potential losses in the ETF and ETN markets are limited to the initial investment when not trading on margin in a stock account. A commodity ETF works similarly to a mutual fund for stocks. They typically consist of a group of commodities and the prices rise or fall with the commodities they represent. However, ETF and ETN products are derviatives and have a different set of risks that sometimes makes them underperform the commodity they seek to replicate.