What are Commodities and are all Commodity Traders Named Winthorpe?
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Learn the basics of commodities investing before you open an account
One of the first movies I remember watching is Trading Places in 1983. The movie revolves around the fortunes of a commodities trader, Dan Aykroyd, and vagrant-turned-trader Billy Ray Valentine, Eddie Murphy.
The movie is hilarious but you already know that…because if you haven’t seen it, you haven’t lived. Towards the end, the two dupe the market to become instant millionaires by trading orange juice on the futures market.
If the idea of becoming a millionaire in the space of less than an hour by betting on the price of O.J. doesn’t get you thinking about investing in commodities, then you should check your pulse.
Before you rush online to open a commodity trading account, let’s take a closer look at what makes commodities different from stocks and why you might want to think twice about investing.
What are Commodities?
Commodities are basic goods and generally raw materials to another finished product. Commodities share common characteristics such as:
- Generally indistinguishable across competitors. For example, oil is oil no matter who drills it from the ground.
- There is little or no extra value added from its natural state. Oil and gold are traded in their raw form without additional processing. There are exceptions like refined products (gasoline) but even these are mostly the same across competitors.
Because of these characteristics, there is generally a fluid global market for commodities with a similar price worldwide. That’s because commodities are fungible, or interchangeable, regardless of the producer.
That’s why there’s a global price for Brent crude, gold and other commodities.
Commodities are usually separated into groups including metals (industrial or precious), agricultural, and energy. Individual commodities include gold, silver, platinum, oil, natural gas, copper, coffee, orange juice, pork, cattle, soybeans, wheat and corn.
How are Commodities Traded as Investments?
Commodities are traded on exchanges just like stocks. Commodities have their own exchanges, most notably the Chicago Mercantile Exchange (CME) and the London Metal Exchange (LME).
Commodities are traded as contracts for future delivery of the good, for actual delivery of gold or a barrel of oil on some date in the future. The price of the commodity for that date depends on several factors including the current price, volatility, interest rates and supply/demand for the good.
In truth, most contracts for commodities are settled on paper and not for physical delivery. You might buy 100 contracts for a July expiration on West-Texas Intermediate crude but you wouldn’t want 100,000 barrels of crude to be delivered to your doorstep.
Leverage of up to 50:1 is often used on commodity futures trading. That means you only have to put down $1 for every $50 and borrow the rest to invest. For example, if you want to buy 100 contracts of WTI crude at $62,000 each (that’s $62 a barrel times 1,000 barrels in each contract) then you wouldn’t need $6,200,000 in your account but only $124,000 to make the trade.
Since commodities are traded globally and generally for a worldwide price, they are traded for 23 hours of the day. That can be nerve-racking for the amateur investor, worrying that some economic release in China is going to cause copper prices to tumble overnight. I remember many sleepless nights trading foreign currencies when I was a trader.
You can invest in commodities through just about any online investing platform. I use Ally Invest for the lower fees and minimums.
What Affects Commodity Prices?
Commodity pricing can be complicated and very volatile. Not only do supply and demand factors influence prices but also inflation and interest rates because you are contracting for a future price.
There are a lot of commodity analysts that spend their entire career following supply and demand factors but sometimes it comes down to what seems like luck. I lost $8,000 overnight once because a refinery exploded in Canada and the price of gasoline shot up. I’ve also made money betting on oil prices because I correctly forecast production numbers from OPEC producers.
The general economic cycle will also affect commodity prices, driving prices for industrial metals in a boom or for safety assets like gold in a recession.
Why Do People Invest in Commodities?
While most people see the rabid commodity traders in the pits and think of fast money investors when they think commodities, the truth is that the majority of trading is done for hedging.
Commodity producers like miners and farmers sell their planned production ahead of time on the exchanges to lock in a price that gives them a profit. Buyers like steel makers and food processing companies buy their planned needs ahead of time to lock in prices before they need it.
Producers and buyers might not hedge all of their production or needs. It depends on the current price and where they think prices might go in the future.
A farmer is in the business of farming, not speculating in corn prices. It can cost thousands to prepare and plant even a small field and the farmer wants to make sure he can get a price for his crop that will pay the bills. For that reason, he sells contracts for September delivery for a certain price.
While most of commodities trading is for hedging, there are also investors and speculators in the market. Because you can use immense leverage, even a small change in prices can become a huge return.
A 5% change in the price becomes a 150% return with 50:1 leverage.
Of course, it can also become a 100% loss on a 2% change in price going in the other direction.
Should You Invest in Commodities?
When prices boom for a commodity, the arguments come out that everyone should be investing in commodities. When the price of gold zoomed to $1,900 an ounce, everyone was reasoning how great it was as a safety asset during stock market turbulence.
The fact is that commodities are not the investment many make them out to be.
Buying or selling futures contracts for commodities pays no dividends and the commodities themselves produce no earnings like company stock. Basically, the only way you make money investing in commodities is if you happen to buy low and sell high.
That may sound easy enough but anyone that has been investing for more than two seconds knows better.
Even if your analysis for some fair value on a commodity is higher or lower than the current market value, prices can remain out-of-whack (to use the technical term) for a long time. Whether the price of oil should be higher because of industrial demand or supply doesn’t necessarily mean the price will move higher before your contract expires.
If you are still interested in investing in commodities, I recommend Ally Invest for its tight pricing spreads, low fees and excellent customer service. Customer service for forex traders is available around the clock from Sunday at 10am through Friday 5pm eastern. Fees are as low as $0.45 per contract and trading is available in metals, agriculturals, indices, bonds and foreign currencies.
Besides just commodities investing, you can use Ally Invest for traditional investing in stocks and bonds plus it’s a full-service bank and loan company.
Check out these other features on Ally Invest for commodity investing
How to Invest in Commodities
Instead of direct investment in commodities, I prefer investing in the producers and miners. That means buying shares of gold mining companies or oil explorers.
Profits for these companies will still very much be affected by the price they can get for the commodity but they might still produce a profit even if prices fall. Some of that profit can be returned as a dividend or reinvested in the company to create more profits. This means you can still collect a return on your investment even if commodity prices remain flat or even fall.
Investing in commodities is not for investors with a low tolerance for risk. Even if you use very little leverage on your account, a small change in the price can be a big drop in your wealth. There are reasons to trade commodities and even some reasons to invest but most investors would be better off with indirect investments in the producers.
Trading places is a fantastic movie! One of my personal favorites. It’s getting up there in age and I feel lik less people know about the movie these days. And great explanation of commodities. You did a great job simplifying it.
Thanks. Trading Places has got to be one of my all-time favorites (and a big part of why I got into equity analysis…ok, maybe it wasn’t a great representation of life as a trader but still fun).