Commodities

While they are nowhere near as popular with traders as currencies, commodities do have a very respectable place in the tradable asset selections of brokers everywhere.

Buying and holding (storing) an actual commodity is most often extremely impractical. For this reason, most commodity trading happens via ETFs, hedge funds, mutual funds and options. Of course, futures contracts are right in the mix as well.

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Commodities

What is a commodity?

A commodity is a basic good, which is considered to be interchangeable with similar commodities. An important part of the definition of a commodity is that its quality is (or rather: has to be) the same from one producer to another. Otherwise, the commodity will cease to be interchangeable.

Commodities are generally raw materials: they are used to produce other goods or services.

In the real world, uniform quality is of course impossible. As long as they meet a well defined "basis grade" however, commodities are considered to be fit for interchanging and trading.

The uniform quality concept is quite self explanatory in the case of commodities. A bushel of wheat or a barrel of oil are considered to be the same, regardless of their origins.

The same cannot be said about mobile phones for instance. In their case, quality differs massively from one producer to another. For that reason, mobile phones are obviously not interchangeable and they do not qualify as commodities.

For exchange-based trading, in addition to the quality of commodities, their quantity is standardized as well. There are "traditional" commodities, such as gold, oil, wheat, corn etc, and newly developed, "exotic" commodities, such as cell phone minutes/credits, internet bandwidth etc.

Some cryptocurrencies may be considered commodities as well, however, there is seldom agreement when it comes to the categorization of cryptos.

How to trade commodities?

As mentioned, commodities are mostly traded through futures contracts. Even the producers of the commodities take advantage of this investment vehicle. By using futures the way they were intended to function, producers hedge their actual investment in production. In fact, this way, farmers can guarantee a set price for their wheat harvest, when the seeds go into the ground.

Speculators on the other hand, aim to cash on in the fluctuations in commodity prices. While this practice is not necessarily predatory, it is a far cry from the intended use of futures contracts.

Needless to say, while the former trader category (producers) actually handle commodities (taking delivery, storing, etc), speculators never do.

According to estimates, only some 2% of futures contracts involve delivery of the physical asset. What this means is that the futures market is dominated by speculators.

Futures traders need to know that these contracts have fixed expiry dates. The owners of contracts that expire have to take delivery of the commodity they bought, or deliver the commodity they sold.

There are some artifices around this conundrum, but they cost extra.

Last, but certainly not least, another way to gain exposure to commodities is by trading the stocks of mining companies, or other corporate entities involved in commodity production.


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