How to Invest in Commodities

Daniel Penzing
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Interested in investing in commodities during this uncertain time? Read our guide to find out how

To get started.

As markets continue to plunge, and you watch your savings dwindle, commodity investing might sound like a good way to ensure that you can weather the storm. In fact, investing in commodities can be a great way to hedge your portfolio against market downturns, and is perhaps a good alternative to more mainstream investments.

But commodity investing is far from easy. There are a number of market players that you should be aware of, and unless you’re willing to do a substantial amount of investment research, you’ll want to keep your portfolio diversified and your equity holdings steady.

The first thing that you’ll notice when you look to invest in commodities is that the market is heavily dominated by big players with deep pockets. Most banks and institutions have a set of analysts who are specialists in commodity trading, and they’ll have a number of different hedge funds spread across a number of different commodities. The market is also dominated by Producers, and while they are commodity market players, they are often in the business of selling the products that they produce. In addition, if you’re looking at investing in commodities in an effort to hedge against a downturn, you’ll want to be aware that any investments in it should be part of a well-rounded portfolio.

Our How to invest in Commodities Guide

Commodities are the primary source of driving the financial markets. However, the vast majority of investors are either misinformed or unaware of the enormous opportunity that exists in these markets. Since the early 2000’s, investors have been putting the same in cash to equity or bond funds, but shun commodities or being ignorant of it. This strategy is falling apart as a bull market in the commodity sector has now gone on for several years.

A somewhat recent report by the Federal Reserve Bank of St. Louis shows that investors continue to shy away from commodities because there is a strong perception that these markets are volatile. The misconceptions about these markets are leading investors to miss out on a golden investment opportunity.

The truth about commodities is that they are more of an investment opportunity than an investment risk. Through adroit investment in commodities, investors can reap huge profits. Here a step by step guide to help determine the factors that affect the price of commodities, thus helping you make wise investment decisions.

Understand What Commodities Are

Commodities have been an important part of the U.S. economy for hundreds of years. Before they were standardized and depended on specific definitions, commodities were goods that people would bring from year to year to sell at the marketplace. In 1871, Congress passed legislation that defined what commodities were – metals, grains and livestock. Since then, the futures exchange has been responsible for defining what a commodity is.

According to the Futures Industry Association, the definition of a commodity is:

A homogeneous product that is interchangeable with other commodities of the same type; is available in different quantities on the market, at any time, in wholesale quantities

There are two distinct types of commodities – physical and financial. Physical commodities are those that can be readily seen and are things that are produced in large quantities. Metals, livestock, grains, energy and financial assets fall into this category. Financial commodities are those that are created from either tangible commodities or financial instruments. They include products such as futures and options on futures.

Commodity Types

In order to begin trading commodities, you’ll need to understand the types of commodities that are available for purchase. Commodities can be broken down into three groups based on the commodity’s classification. Each of these groups is further broken down into common commodities and goods, which are generally traded through the futures market.

First, there’s energy resource commodities. This includes oil, natural gas, coal, and any other primary sources of energy. Crude oil is the most widely traded commodity in the commodities markets.

Next, there’s metals and minerals. Aluminum, copper, zinc, steel, lead, nickel, and gold are popular examples of metals.

Lastly, there’s grain and the softs. These consist mostly of food products and other foods. Soybeans are the most widely traded commodity in this category.

All else considered equal, a contract that is based on a specific type of commodity will normally be about 55% more expensive than one that is based on another kind of commodity. Plain and simple, metals and energy resources commodities are more expensive in comparison to goods.

Choose the Right Type of Commodity to Buy (And the Right Broker)

Whether it’s gold, oil, or any other commodity, you can take advantage of fluctuations in its value by investing in it. However, it’s important to recognize that commodities are inherently risky investments. So before you start trading commodities, you’ve got to choose the right type of commodity to buy.

Like stock, commodity prices fall and rise over time. With stocks, the company’s share price may rise or fall because of changes in the market, but with commodities, the commodity’s price may rise or fall because of changes in supply and demand. If the economy improves, demand for a commodity may increase, driving the price up.

Commodities are traded on futures markets like trading stocks are traded on the stock market. Futures are contracts and agreements to exchange goods at a particular price at a future date, thus if the price of the commodity rises, you can buy the contract at a low price, sell it for a higher price later, and make a profit.

You should choose the type of commodity that you want to invest in based on your risk tolerance, your goals and financial situation. Each type of commodity that you can invest in will have different risks, rewards, and price trends, and we’ve covered them in detail in the article on different types of commodities.

Understand the Risks of Investing in Commodities

Many people are fascinated by commodities or commodity investments, but are unsure of how to obtain them or who to turn to for advice. The following is a simple definition of commodities, as well as some facts about commodity investing.

Commodities are goods that are exchanged in a free market. That is, in a free economy, you are able to sell and buy goods without interference from the government.

Among the most common examples of commodities are things like gold, silver, platinum, wheat, crude oil, coffee, soybeans, livestock, sugar and corn. In some cases, stocks, bonds and securities are also included in commodities.

Commodities give investors a diverse portfolio of goods. Generally, they represent the weather or the season. For example, if agriculture is in good condition, pumpkins and corn usually do well. If there is great weather for growing crops, there will be more food to export and so the demand for those foods increases. This change in prices is known as supply and demand.

Types of Risk

The first step in investing in commodities is to understand the risks associated with the security. When you own commodities or other futures contracts, you must be aware of these risks at all times to protect your investment and maximize the return.

Market Risk

Market risk refers to the possibility that the overall price of commodities will decrease and your investment will lose value. If market risk exists, you can hedge your investment against these risks. Think of market risk as if you were going into a casino. The last thing you want is to lose your shirt and go home amount you came. In an investment environment, making smart choices can reduce the chances of it happening. Market risk is normal when you are looking to make a profit over a long period of time.

Delivery Risk

Delivery risk means that the seller may not have enough supply of the commodity to fulfill what you purchased and you have to shift to another commodity. It is an important responsibility that investors should know so they can take necessary steps, like hedging, to ensure their investment is safe.

Liquidity Risks

Liquidity risk refers to the constant need to sell and buy commodities with a high volume of trading. This type of commodity is risky in that you may not always be able to get the amount of supply that you need fast enough or at a certain price. More trading activity may have a big impact on the overall price of the commodity.

Advantages of Investing in Commodities

· Investing in commodities is akin to having an exposure to the entire world economy.

· Commodities include all the major raw materials such as precious metals, base metals, softs and agricultural products.

· Commodities companies make up some of the best long term investments out there.

· Metals and precious metal mining companies are less volatile than many other sectors.

· Decline in commodities may indicate downturn in the global economy.

· Commodities futures are an effective hedge against inflation.

· Provides a long-term hedge against inflation.

· Investment in commodities offers some of the best long-term returns on the market.

· By investing in commodities, your portfolio can have a significant allocation to assets that usually perform well during rising inflationary periods, in economies that may have low, stagnant growth in the conventional assets, and in times when the economy changes tax brackets.

· Investing in commodities can provide a hedge against inflation as many commodities often rise when the costs of living are rising.

· Investing in commodities also serves as a hedge against currency risk – commodities are for the most part denominated in US dollars.

· Commodity profits are not dependent on the overall economic climate, which means that they can be very effective in bear markets.

Be Cautious

Commodities come in all shapes and sizes. There are not many commodities, but some of the more familiar ones are silver, gold, oil, and corn.

Commodities are also a subject that many people are educated about. But, commodities are not the end-all investment product. Investing in commodities can be profitable, but there are several ways that the investor could get burned by commodities, especially in the short term.

The first way that you could lose money is the risk of transaction costs being higher than the expected profits. Transaction costs consist of the commissions of the people who you are trading with. You also have to consider commissions when you are buying or selling your commodities.

The next way you could lose your investment is if commodity prices tend to be volatile. The more volatile the prices, the more risk there is that your commodity will be priced high, and you will have to sell at a loss. The more volatile the prices are, the more risk there is that the prices will fall, and you will have to sell at a loss.

The last risk that one takes when investing in commodities is that their investment might be stolen. When you are investing in commodities, you must find a way to secure your investment. This is a risk that you will have to weigh, because you do not want to risk your commodity being stolen.