Ever wondered how the price of gold or oil is determined? No? Well let’s discuss it because you should know it anyway. The prices of these and other goods are determined within large exchanges such as the Chicago Mercantile Exchange (CME) and the New York Mercantile Exchange (NYMEX), but let’s first establish what makes a commodity a commodity.
- A commodity is a basic good which is nearly identical to other commodities of the same type and is commonly traded on exchanges.
- Common commodities include metals, agricultural goods, and energy products.
- Commodity prices are determined on commodity exchanges.
- Trading commodities is much closer to speculation than investing.
What is a Commodity?
A commodity is a commonly traded good that is interchangeable with other goods of the same type. For example wheat grown in Iowa is for the most part indistinguishable from wheat grown in Kansas. Agricultural products with their nearly perfect similarities are a great example of commodities. Whether the corn is grown in Iowa or Kansas it is still corn. Though commodities are interchangeable, different grades or quality of the commodity can be traded. For example, there are varying qualities of oil and natural gas traded.
Types of Commodities
The common classifications of commodities traded are metals, agricultural goods, and energy products.
- Metals: This group is composed both industrial and precious metals. Industrial metals include metals such as zinc, copper, and nickel that are commonly used in the construction of many goods. Precious metals include metals such as gold and silver that derive their value not by their industrial applications, rather for their intrinsic rarity.
Agricultural Goods: This group is composed of both food products and livestock. Food products includes foods such as corn, wheat, sugar, milk, and orange juice. Livestock is comprised of lean hogs, live cattle, and feeder cattle. (The difference between feeder cattle and live cattle? Feeder cattle is cattle that will be placed on a feedlot, fattened, then slaughtered to produce delicious steaks or burgers).
- Energy Products: This group is the most diverse of the three major groups. It includes products such as ethanol, natural gas, propane, and gasoline. Energy products have various uses including construction of petrochemical products to providing fuel for homes and vehicles.
Like stocks or bonds, commodities trade on long standing markets (most of which predate the largest stock and bond markets). The largest commodity market in the U.S. is the Chicago Mercantile Exchange (CME) followed by the New York Mercantile Exchange (NMEX) which together account for the majority of commodity trades made in the U.S.A. There are also many large international commodity exchanges such as the London Metal Exchange (LME) based in London, UK and Euronext which is based in several major European cities.
How does an exchange ensure that the wheat or livestock being traded is actually worthwhile grain or animals and not disease ridden goods? Exchanges establish a basis grade which establishes a minimum accepted standard that a tradable commodity. Also called a “par grade” or “contract grade” the purpose of the basis grade is to ensure that when trading commodities it is truly “apples to apples” trades.
There are two primary ways to trade commodities: spot and futures markets.
- Spot Markets: When trading commodities in the spot market an investor is buying or selling the commodities at that very moment. This trading is done at the spot price, which is simply the market price of the goods at that time. A different way to look at spot markets is that when trading in the spot market you are truly trading “on the spot”.
- Futures markets: When trading commodities in the futures market an investor is not buying or selling the commodities directly but is instead trading futures contracts. For now just know that a futures contract is a highly standardized contract that obligates the holder to buy or sell a set amount of goods at a set price. These contracts tend to greatly fluctuate in price based on the perceived value of the underlying assets and predictions of future market circumstances.
Speculation vs. Investing
Now that you are more informed about commodity trading here is where I throw my $0.02 in.
I DO NOT recommend commodity trading for the average everyday investor.
Commodity trading is a highly specialized field in which highly savvy and well informed traders and investors operate and seize on market opportunities. In addition most trades are made “on margin”. This means that losses and gains become greatly magnified as the transactions are highly leveraged. A final reason is simply the speculative nature of commodity trading. There are limitless variables which can alter commodity prices and result in enormous volatility in the prices of commodity.
If as an investor you really want to invest in commodities, my recommendation is to get exposure through ETFs or mutual funds based in commodity-related businesses. For example an oil and gas mutual fund would own stock in different companies directly involved in the production and distribution processes.
- Commodity: A commonly traded good that is interchangeable with other goods of the same type.
- Basis grade: The minimum quality of a commodity that must be met in order to be traded and is established by the commodity exchange on which it will trade.
- Spot market: A market in which commodities or securities are traded for cash and settlement is immediately effective.
- Spot price: The current market price at which an asset is bought or sold for immediate payment and delivery.
- Futures market: A market in which commodities or securities are traded via futures contracts for delivery on a specified future date.