What Is a Commodity? Definition & Basics for Investors

What Is a Commodity? Definition & Basics for Investors

Key Takeaways

    Commodity examples include energy, metals, grains, livestock, and other foodstuff

    Commodity trading and investment alternatives include derivative contracts, exchange-traded funds, and shares of commodity producers 

    Learn about the fundamental factors that can move commodity markets

Commodity markets may conjure an image of a freewheeling world of high rollers living hard and taking outsize risks, and there’s some historical truth in that image. But in a sense, all investors—whether big, small, or in between—participate in the commodity markets. If today, for example, you ate breakfast, made a cup of coffee, adjusted your thermostat, or filled your gas tank, guess what? You’re already a commodities “player”.

Commodities affect our lives every day. So, just what is a commodity, and how does commodities trading work? How does someone “invest” in commodities? Here’s a brief introduction, including a commodity definition and few pointers for investors.

Commodity Definition: Categories and Types

Simply defined, commodities are raw or unprocessed materials that can be bought or sold and are used to make something else that eventually is consumed. For trading purposes, a given commodity typically is interchangeable, or fungible—one bushel of corn is considered pretty much the same as any other. Commodity examples include those that are pulled from the deep underground or plucked from right on top of the ground.

What Is a Commodity? Definition & Basics for Investors

Of these commodities, crude oil is currently the world’s most actively traded. The total number of futures and options traded on exchanges worldwide reached a record level of 46.77 billion contracts in 2020, up 35.6% from 2019, according to the Futures Industry Association data. 

Who Trades Commodities?

There are two broad types of commodity market participants:

    Hedgers (aka “commercials”). These are businesses that are actually producing, shipping, processing, or otherwise handling the commodities in question. They include oil and gas producers and refiners, miners, grain millers, farmers, and meatpackers.Speculators. These include banks, hedge funds, and individuals who trade commodities. They speculate that the price of a commodity will go up or down within a certain time frame, and they place trades with the aim of turning a profit.

What about Futures Contracts and Futures Exchanges?

Both play a major part in the commodity markets. Futures contracts are standardized agreements between buyers and sellers where both parties agree to buy or sell a specific amount of a particular commodity at a predetermined price, at a specific date in the future. For example, one crude oil futures contract specifies 1,000 barrels of West Texas Intermediate crude, the U.S. benchmark.

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What “Fundamentals” Move Commodity Markets?

Weather is a major factor for many commodities. Droughts and floods hurt farmers’ harvests, cold snaps boost heating fuel demand, hurricanes disrupt oil production and shipping, and so on. Commodity market professionals constantly keep an eye on the weather forecasts. Wars, trade disputes, and other geopolitical developments can also affect commodity markets.

Altogether, these factors are difficult to predict with accuracy, which could make commodity markets prone to sharp, sudden price swings—or greater “volatility” when compared to traditional stocks and bonds. Investors should carefully consider their appetite for risk.

How Do You Trade or Invest in Commodities?

Understanding the commodity definition is one thing, but knowing how to participate in this market (aside from filling the grocery cart and gas tank, of course) is quite another. 

For individual investors, there are several avenues into the commodity markets that don’t involve planting your own wheat or buying your own drilling rig. These include:

    Futures contracts. A futures contract is an agreement to buy or sell a certain amount of a commodity at a certain price in the future. If the price of a futures contract rises, the buyer, in theory, can profit; in contrast, the seller of a futures contract potentially profits if the price goes down (this is known as going short). In futures markets for retail traders, actual “delivery” of a commodity is rarely allowed; usually contracts are “closed out” prior to expiration. Options on futures. Put or call options based on crude or gold, for example, are traded on many futures exchanges. These contracts grant the option buyer the right, but not the obligation, to buy or sell a specific futures contract at a specific price on or before an expiration date.  Exchange-traded funds (ETFs). ETFs are marketable securities that trade like common stocks and can be bought or sold on an exchange. Many ETFs are linked to a single commodity, a basket of commodities, or a commodity index.Traditional stocks. Many publicly traded companies have direct exposure to commodities and commodity markets (miners, oilseed processors, and oil and gas exploration companies, for example) or indirect exposure (such as farm equipment manufacturers).

A Brief History of Futures

Futures trading, as it relates to the commodity markets, has deep roots in the soil.

1848: CBOT. Commodity futures trading as we know it began in 1848, when a group of grain merchants established the Chicago Board of Trade (CBOT). A few years later, the CBOT established the first recorded “forward” contract—a predecessor of the futures contract—based on 3,000 bushels of corn.

1872, 1898: NYMEX, CME. Other exchanges sprouted as America grew, including the New York Mercantile Exchange (NYMEX, founded in 1872) and the Chicago Mercantile Exchange (started by butter and egg merchants in 1898), according to CME Group.

2000: ICE. The Intercontinental Exchange (ICE) launched in 2000 as a platform for energy trading. In 2007, ICE added coffee, sugar, and cocoa (“softs”) to its commodities lineup when it bought the New York Board of Trade (NYBOT).  

2007-2008: Consolidation. Also in 2007, CME and CBOT merged their exchanges into one company, CME Group. The following year, CME Group acquired NYMEX, to add energy and metals products to its commodity offerings: grains, oilseeds, and livestock. 

Today, CME Group tops the list among 50-plus futures exchanges worldwide. (China, India, and several other countries also have commodity futures exchanges.) In 2017, an average of 16.3 million contracts changed hands every day on CME, or about 16% of global futures and options trading.

Futures exchanges, much like their counterparts in stocks, provide a centralized (and now mostly electronic) forum for hedgers and speculators to conduct business. Both hedgers and speculators are essential to a functioning, “liquid” market, where willing buyers can find willing sellers, and vice versa.

“Hedgers and speculators go hand in hand—if you took one away, there simply would be no market,” Chicago-based CME Group stated on its website. “Hedgers transfer risk, and speculators absorb that risk. It takes both types of traders to bring balance to the market and keep trades moving back and forth.”

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