When it comes to investing, diversity is always a good idea. And that’s why including commodities in your investment portfolio can be so useful.
But do you know where and how to trade them? If you’re wondering how to get started with commodities trading, keep reading to learn several ways to invest in commodities, as well as the benefits and risks of trading them.
Definition of Commodities
A commodity refers to a primary good. There are many examples of commodities that we see in our daily lives, from the oil in our vehicles to the grain used to make our breakfast cereal.
There are several types of commodities, but what they all have in common is that they are physical objects traded in the world markets.
Commodities are usually separated into 4 main groups:
|Precious Metals||Energy||Agriculture||Industrial Metals|
Commodity trading involves the exchange of basic production goods. Although there are a lot of cases where trading the physical good is the go-to option, investors can also do this through “futures” options.
Commodities markets can sometimes be complex. These are the seven main ways to invest in commodities:
- Purchase Commodities On Spot: This method means that you will purchase and receive the actual asset. This method requires logistics and storage, which you will have to take care of. The advantage of this method is that you do not have to go through a third party. You can search for a dealer of a particular good and when you no longer want it, that dealer will often repurchase it. But taking care of storage and delivery logistics is often too much effort for a retail investor.
- Exchange-Traded Funds (ETFs): ETFs are private funds that trade on a public exchange. They replicate the performance of a commodity-related asset. Commodity ETFs can provide a cushion during a stock market slump and provide a more cost-effective way to invest in expensive commodities.
- Futures or Forwards: Futures are legal standard agreements in a regulated market where you commit to buying or selling a commodity for an exact price at a specified future time. Forwards generally trade OTC (over the counter), and are custom agreements, so they have more flexibility than futures contracts. The primary difference is that the OTC option does not trade in a regulated market, meaning there are no warranties. Futures and forward contracts involve dealing with speculation and having a good understanding of business. With futures contracts, traders bet on how prices will move. Based on that, they can either buy or sell a contract.
- Investment in Specialized Companies: This is an indirect method to trade commodities. You buy stocks from companies that produce or are part of the supply chain for that particular commodity (oil, agriculture, and more). The risk comes from the companies, business operations, or other company-associated factors, as opposed to the actual values of the commodities that may negatively influence prices.
- Mutual & Index Funds: These funds involve putting money into a pool alongside other people. A professional manages the cash invested daily (this option involves higher fees). These funds are a good choice for beginner investors as the first step to commodities trading. The disadvantage is that finding a fund that holds the investments you want can be challenging.
- Options: A good alternative to a futures contract, options give investors the right to buy or sell an asset without being obligated to do so at a set price. Options contracts have specific expiration dates investors must follow.
- Pools: Pools are managed by a CPO (Commodity Pool Operator) who collects money from multiple investors to pull into one fund and then invest it in a commodity.
Commodities prices can often fluctuate widely due to changes in supply and demand. These changes may add more risk to your portfolio as they sometimes suffer sharp falls but also sharp rises.
Deciding exactly how you want to invest in commodities will depend on your investment goals. Commodities involve risk by default, so it’s worth taking time to research and learn before finalizing your investment plan.