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Commodities are traded on what is known as a commodities exchange such as the Chicago Board of Trade (CBOT) or the New York Mercantile Exchange (NYMEX). In this way, you can buy and sell commodities in a similar way as stocks. You can also buy commodities directly. For example, you might purchase Canadian gold maple leaf coins or bars of gold and store them somewhere safe as a hedge against inflation risk. There are also ways to get indirect exposure to commodities by investing in stocks, mutual funds, or exchange-traded funds that work with specific products or materials. For example, if you don't want to buy gold directly, you can buy an ETF managed by people who buy gold bullion. Or you could buy shares of a company that mines gold. Taking this approach is generally less risky and easier to understand for the average investor.
There are generally two types of commodities, ‘hard commodities’ and ‘soft commodities’. Hard commodities include crude oil, iron ore, gold, and silver and have a long shelf life. Agricultural products such as soybean, rice or wheat, are considered ‘soft commodities’ since they have a limited shelf life. These commodities have to be similar and interchangeable or ‘fungible’. For example, soybean from one country or market should be of the same quality as soybean from another, or gold from one country should be of the same purity as gold from another.
Commodities are usually naturally-occurring or agriculturally grown materials that can be traded (that is, bought and sold). Due to their nature, commodities of the same type and grade generally do not differ much between producers. Thus they are interchangeable and are priced similarly, if not equally.
Commodities are crucial to our everyday lives, which could explain why investors see the value in trading them. When commodities are traded, investors aren’t necessarily looking to purchase the right to claim the physical commodity. After all, if you were trading the good itself, (let’s say it’s livestock) transferring numerous cattle between owners could be quite cumbersome!
Commodities are often bought and sold on exchanges via futures contracts (also known as derivatives). You can read our article on futures if you want more information, but these contracts are basically agreements to buy or sell a certain amount of a good at some point in the future.
The prices set in commodity futures contracts are based on speculation. If the contract expires and the commodity is selling at a lower price than what was agreed upon in the contract, the buyer profits. But if the price of the commodity rises, the buyer loses out on some money.