What are Commodities?
Investing in the stock market is about buying stocks and shares or investing in mutual funds. Apart from the stock market, there is one more market where one can make investments with the objective of earning money. This is the commodity market. The commodity market or commodity exchange is where trading happens in commodities. So, what are commodities? They are goods or raw materials that are used to make other products. For example, wheat is a commodity. This is a raw material used to make bread and other food products. Similarly, gold is a commodity that is used to make gold ornaments and other jewellery items. Investing in commodities, therefore, involves buying physical goods that are of value and have some utility.
Commodities are classified under two major heads. They are hard and soft commodities.
- Hard commodities: These commodities usually need to be mined or obtained from the earth. They are commodities that are naturally found in some form or the other. Hard commodities include:
- Metals: These include precious metals like gold, silver, and platinum. Other metals traded are copper, aluminum, and palladium.
- Energies: These include those commodities used as a source of energy. Crude oil, Natural gas, gasoline, heating oil are energy-related commodities.
- Soft commodities: These commodities need to be grown, either in a field or from a ranch. These include:
- Crops: These include all agricultural products like corn, wheat, soybean, coffee, cotton, sugar, and rubber.
- Animal products: These are obtained from animals and include cattle meat, pork, and animal products like wool.
How to Invest in Commodities?
Commodities are physical goods, unlike stocks and mutual funds that are virtual or exist in the form of a document. This is why the commodity market is different from that of the share market. It requires a different approach to investing. If you were wondering, how you could invest in commodities, here are some of the ways:
- Buy physical commodities: This involves actual buying of a physical product like wheat, corn, or meat. You can buy the products at a particular price and then sell it at a higher price. This investment method is essentially meant for those who deal with the products on a daily basis. A common investor would not be comfortable with this method, as it involves having to store the product. You also need to protect the product against pests and the impact of weather. Buying and storing metals is easy. Since they are expensive, you need to safeguard them against theft. This method of investing is not usually meant for retail investors unless you plan to buy gold and silver.
- Buy commodity related fund or stocks: You can include commodity as a part of your investment strategy in the share market. You can buy shares of those companies that work in the commodity sector. For example, you can buy shares of an oil and gas company. You can also buy mutual funds that invest money in commodities or exchange traded funds. Here you are not buying commodities or investing in the commodity market but are buying securities from the stock market that in turn invest in commodities. This is a way by which you are invested in commodities without having to actually buy them or enter the commodity market. This approach is suitable for those who are new to investing and do not have much knowledge about the commodity market.
- Buy derivatives from the commodity market: This is an actual investment done from the commodity exchange. Here, you buy a product known as a derivative. This is an advanced investing method, where you are essentially speculating in the commodity market. Derivatives involve a contract between two parties. While there are many types of derivatives, the common ones you can invest in are futures and options.
Futures or a futures contract is an agreement to buy a particular commodity at a pre-agreed price in the future. Here, you are not buying the commodity, but have a contract to buy them in the future. This is a technique used by speculators who buy commodities the prices of which are likely to go up in the future. When you buy futures in gold at a particular price, you are buying a contract in gold at a particular price for the future, which could be a month from the date of buying the future. On the date when the contract expires, you will buy gold at the prevalent market price. If the market price has gone up, you end up with a profit. In general, investors do not wait for the contract to expire. When the price goes up, they sell it before expiry date and make money,
The other popular investment is an option. The difference as compared to futures is that in options, you have the right to buy the particular commodity on the date of expiry, but there is no obligation. If you believe a particular commodity’s price is going to go up in one month time, you will buy calls of that commodity. A call is an option that indicates increase in price. On the other hand, if you feel its price is going to decline, you can buy a put option. A put is where you feel the price is going to go down. You can exercise your call/put before the expiry date to make a profit. If the trade doesn’t go your way, you can end up with a loss.
Futures and options, or derivatives are a common way in which investment in the commodity market happens.
How the Commodity Market works?
The commodity market is in some way similar to the stock market, but there are differences too. The similarity is that you need to invest your money to buy commodities through an account with a broker. The difference is mainly in the volatility. It is well known that the stock market has major ups and downs. This is one of the reasons why people are scared to invest in the stock market. The commodity market is considered even more volatile than the stock market. Prices of commodities can undergo major changes very quickly. For instance, a crisis in any of the Gulf countries could lead to a sudden increase in crude oil prices. This can have a big impact on your investment.
At this point, please do note that the commodity market is not meant for the newbie investor, whose knowledge of this market is too limited. It is only meant for those who have some understanding about the market, especially the volatility. You must be ready to accept major fluctuations in prices. In the stock market, you would actually be owning a certain number of shares of the company. In the commodity market, you would buy futures and options. You do not own anything here but are only speculating. Individual investors generally do not physically buy commodities.
Because of the nature of the commodity market, financial experts advise that you do not invest more than 5 or 10% of your overall assets in commodities. If you are an experienced investor with knowledge about the commodity market, then you can consider investing more. Else, restricting your investment is advised. To invest in commodities, you need to understand how the market works. You also need to understand how that particular commodity is doing. For example, if you are investing in wheat, you need to know about the wheat market and whether wheat prices are expected to go up or come down.
Breaking it down
When it comes to the actual working, let’s assume you are buying oil futures. Unlike the stock market, where you can buy 1 share or 10 shares; in the commodity market, you buy predefined numbers of contracts. For example, if you want to deal with crude oil, you can buy contracts for different months. You would buy an August contract expiring on the last day of August. The unit of purchase would be in terms of barrels and you would need to buy a minimum of 100 barrels (100 futures contract). For example, the August price is 500, which means one barrel would cost 500 at the end of August. You need to spend 100 x 500 = 50000 to invest in crude oil.
In practice, you need not pay 50,000. You only need to pay a part of it known as margin money. For investing in futures and options, brokers give you leverage. This allows you to invest more money that you actually have. In the above example, if you have 10,000 you can invest it to buy 50,000 worth of futures contract. At the end of August, depending on the price of crude oil, the contract would be settled. As an investor, you will not usually wait until the last date but will settle before.
If your target price is reached beforehand, you can sell much earlier. You need to track the prices of crude oil. When the price reaches the target price you had in mind, you can sell it. This is just like the stock market, the only difference is it can be more volatile. If you feel that crude oil prices are going to fall, then you can short it. Shorting is selling first and then buying back later. This is suitable where prices are likely to fall. If however, through the month of August the prices do not rise, then you will end up making a loss.
Leverage: a boon or a curse
When you trade in commodities futures or options, the broker would give you leverage or allow you to invest much more money than you actually have. This is a great boon, as you need not have 100,000 in your account to buy options worth 100,000. You may need just 10,000 or 20,000 (depending on how much leverage your broker provides). This is a great way to make huge profits. You would be buying futures worth 100,000 by investing 20,000. If the prices go up, then you can make 150,000. So your profit will be 50,000 with an investment of just 20,000. This is the reason why commodities futures and options investments are popular. They allow you to earn huge profits.
Leverage can also be a curse. You can lose everything you have if the prices fluctuate. Unlike stocks, where you can hold on for a long term and wait, futures and contracts have to be settled on the date of expiry. You can not only lose the 20,000 you have invested but you may need to pay 20,000 more to the broker. Investing in commodities can make you lose big money if you do not understand how the market works.
How to invest in commodities with low risk?
If the idea of investing in the commodity market interests you, but you are not comfortable with the risk, then here are some tips to invest in commodities with lesser risk:
- If you do invest in commodity future or options, don’t use the entire leverage. If you have 10,000, stick to investing for that much money or a little more. This will help you reduce your risk.
- Don’t invest everything in one commodity. Diversify and reduce your risk by investing in different types of commodities.
- Never invest in something you don’t understand.
- If you know technical analysis, you can apply it to the commodities market to make money by using tools to predict price movement.
- Invest in commodity exchange traded funds. This will help you to be invested in that commodity, but not directly. You can get the benefit of investing in commodities without having to risk investing in derivatives.
- Invest in mutual funds that invest in commodities or that have a theme related to commodities.
- Invest in precious metals and take delivery instead of speculating on futures and options. These are easy to store and can be held for long term, where its value can increase.
- Futures and options involve trading and not investment. To be invested in the long run, ETFs and precious metals are the best ways to benefit from commodities.