What is commodities trading?

Learn how commodities trading has different characteristics to stock markets, so can be a great way to diversify your share portfolio.

A bag with oil written on it and a US note bundle.

Image source: Getty Images

What are commodities?

Commodities are basic physical assets. They can be anything from precious metals like gold and silver to staple foodstuffs like corn and wheat, and even energy resources like crude oil and natural gas.

Put simply, commodities are the raw materials required to keep the economy going. They are the inputs companies use to create the finished products they sell to customers.

And, just like other assets, the prices of commodities can vary based on the forces of supply and demand. For example, when the economies of large countries (like China or India) are in a growth phase, they might have many large-scale construction and infrastructure projects on the go. This could increase global demand for iron ore – a key component of steel, which is essential for the construction industry. This means the price of iron ore will likely rise.

Constrictions in supply can also increase prices. For example, when Russia invaded Ukraine early in 2022, many Western countries banned Russian oil and natural gas imports. This resultant supply shock caused energy prices to skyrocket.

The fungibility factor

Apart from being fun to say, fungibility is a key attribute of commodities.

If something is fungible, it is mutually interchangeable with another item of the same type. So, a kilo of corn harvested in Central America is essentially the same (and has the same value) as a kilo of corn harvested in Europe. There is one global market for corn which dictates the price a buyer will have to pay.

This is in contrast to finished goods and products, which can differ in price for all sorts of reasons. For example, we might consider one washing machine brand more high-end than another because it has additional features or uses better-quality materials. 

This means it can fetch a higher market price and wouldn't be considered an equal substitute for the cheaper machine.

What is commodities trading?

So far, we have only spoken about commodities as the raw material inputs for other parts of the economy. The construction industry requires iron ore and other industrial metals for building materials, food manufacturers need basic foodstuffs like corn or rice to process into food products, and the airline industry needs ample supplies of oil for fuel.

However, everyday investors can also speculate on commodity prices. Buying and selling commodities on the commodities markets to try and make a profit is referred to as commodities trading – and it's very similar to trading other financial assets like shares, bonds or foreign currencies.

Just as you might buy stock in a company you think will increase in value over time, you can also buy units of a commodity you believe is undervalued. If you're right, and the commodity's price increases, you can sell your units for a profit, just like any other asset. The price could also fall, in which case you might make a loss on your investment.

Of course, transporting and storing physical commodities can be very costly. If you buy a tonne of iron ore thinking its price will rise, you have to find somewhere to put it until it's time to sell it. 

This means that commodities traders rarely buy the physical commodity itself – instead, they typically trade derivative contracts called futures.

How do futures contracts work?

A futures contract is an agreement between two parties to exchange an underlying asset for an agreed price at a future time. Many companies use futures contracts to hedge against unwanted movements in the prices of the raw materials they need to run their businesses. 

For example, an airline might buy futures contracts for oil. That way, if the oil price suddenly rises, they can still purchase it for the price agreed in their futures contracts. This gives them certainty about the most they will pay for oil, allowing them to forecast their costs better.

However, futures contracts have value in their own right. If the price of oil does rise, the futures the airline bought become more valuable. This is because these contracts now allow the holder to buy oil at a lower price, sell it instantly on the open market, and lock in a profit.

Similarly, if oil prices fall, the futures lose value because no one would choose to buy oil for a price higher than its market price.

This means that the prices of futures contracts tend to move in concert with the price of the underlying asset. This allows traders to use futures contracts to speculate on price movements without ever having to buy and store the physical commodities themselves.

Types of commodities

Commodities are broadly grouped into four categories.

1. Metals: Precious metals like gold, palladium and platinum, industrial metals like copper and iron ore, and rare earths like neodymium and dysprosium.

2. Energy:  Crude oil, natural gas, and coal, among other fuel sources, heat and electricity.

3. Livestock and meat: Live cattle, sheep and goats, beef and other meats, and milk.  

4. Agricultural: Crops of wheat, rice, cocoa, and soybeans, among many other farming outputs.

The first two types of commodities – metals and energy – are usually referred to as 'hard commodities', while the second two – livestock and meat and agricultural – are called 'soft commodities'.

Commodities vs the stock market

Commodity prices can often move differently to share prices, which means commodities can provide diversification benefits for investors with portfolios comprised only of shares.

For example, precious metals – particularly gold – can be great defensive assets. Gold has a long history of preserving its value, so investors flock to it when other financial markets get rocky. This means that gold can provide a hedge against potential share price losses in a downturn or recession.

Oil can also provide a hedge against falls in the stock market. If oil is cheap, energy and transportation costs are lower for businesses, improving companies' operating margins. When oil prices increase, margins get squeezed, and business conditions become tougher.

While gold prices tend to be relatively stable over the long term, other commodity markets can be more volatile than the stock markets. Droughts or oversupplies can cause sharp movements in the prices of livestock, meat and agricultural commodities. This can make them riskier investments, particularly for those unfamiliar with commodities markets.

Pros and cons of trading in commodity-based shares

Commodity-based shares are companies involved in the production of certain commodities. Exchange-traded funds (ETFs) also track the prices of certain commodities, either by investing in the physical commodity directly or by buying futures.

Pros of investing in commodity-based shares include:

  • It's easier: You can trade commodities shares like any other share in your portfolio without opening another trading account on a different platform.
  • Diversify in a single trade: You can buy shares in mining companies like BHP Group Ltd (ASX: BHP) that produce a range of metals and energy commodities. Or you can buy units of a commodity ETF – an ASX lithium ETF for example – that invests in a basket of different commodities or pursues a more complicated commodity trading strategy. These investments expose you to multiple commodities in a single trade. 

While the cons include:

  • Share prices may not move with commodity prices: Companies are exposed to other risk factors besides just commodity price changes. For example, a particular company may be impacted by legal issues, which could cause its share price to drop even if commodity prices remain high.
  • Futures may not reflect spot prices: Although futures contracts derive their value from the underlying commodity, they may not always move in complete tandem with one another. This means that some commodity ETFs may also not directly reflect the value of the commodity. 

4 ways to invest in commodities 

Direct investment: You can buy the physical commodity directly from a dealer. However, if you do choose to invest directly, remember that you have to physically take ownership of the commodity and store it somewhere. This isn't too difficult if you're investing in something like gold, but it can be tricky if you're thinking of buying oil barrels or cattle. Hence why most commodities traders use futures.

Futures contracts: As discussed, futures contracts allow investors to speculate on movements in commodity prices without having to take ownership of the commodity.

Commodity stocks: Usually companies involved in the production of commodities. They include mining stocks, energy companies, dairy producers, and commercial farming companies. As we mentioned in the previous section, the price of commodity stocks can be influenced by many other risk factors, which can often cause them to deviate significantly from the price of the commodity the produce.

Commodity ETFs and mutual funds: These investment vehicles pool money from multiple investors to invest in either commodities or futures contracts. Funds that invest in physical commodities tend to track commodity prices closer than those that invest in futures. Funds can offer other benefits. Some will track a basket of commodities, which means they can provide instant diversification. This can be a great way for investors to start adding some commodities exposure to their portfolios.

This article contains general educational content only and does not take into account your personal financial situation. Before investing, your individual circumstances should be considered, and you may need to seek independent financial advice.

To the best of our knowledge, all information in this article is accurate as of time of posting. In our educational articles, a 'top share' is always defined by the largest market cap at the time of last update. On this page, neither the author nor The Motley Fool have chosen a 'top share' by personal opinion.

As always, remember that when investing, the value of your investment may rise or fall, and your capital is at risk.

The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.