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What are Commodities and How Can I Profit from Them?

By ID Analysts on October 1, 2012

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What is a commodity?

In stock market terms, a commodity is a physical substance that is traded on a stock exchange. 

Pork bellies, uranium, wheat. These are just a few of the commodities bought and sold every second throughout the world. But commodities aren’t just for traders. Ordinary investors looking to protect their financial holdings against inflation, or benefit from global scarcity in certain natural resources, should consider adding commodities to their mix.

Let’s start with the basics. Commodities are physical substances, many of which trade on an exchange, and there are two types: Hard commodities are metals, such as copper, oil, gold, platinum and zinc; soft commodities are things we eat—corn, rice, wheat, milk, cocoa, etc.

To be tradable, commodities must be “fungible.” That is, any one unit of the commodity should be exactly like all the other units in terms of value. For example, 1 ton of cocoa from Brazil should be interchangeable for 1 ton of cocoa from Indonesia. By contrast, non-tradable commodities such as diamonds lack fungibility, due to their varying sizes, cuts, colors and grades.

Why are Commodities Traded?

Commodity exchanges exist to reduce risk for both buyers and sellers. For example, drilling an oil well can cost millions of dollars. To obtain financing or justify the present-day investment, an oil company may want to lock in a price for its output, ensuring that its production costs will be more than covered.

Similarly, companies that need a lot of a specific commodity, say cattle feed providers, may also want to lock in a price to manage their future input costs.

There are two ways to trade commodities: (1) Spot trading, in which the commodity is bought or sold for immediate “on the spot” delivery,” with pricing reflecting current supply and demand conditions; and (2) futures contracts, through which a buyer and seller agree to exchange a fixed amount of the commodity at a fixed later date for a fixed price. 

Two Ways to Play

Commodity futures contracts are best left to adrenaline junkies and well-connected experts; they’re way too risky for most investors to trade solo. Sure, brokerage firms make it easy to invest in such contracts. But almost all futures must be bought on margin—a small down payment locks you into large potential gains AND losses.

Another reason: it’s extremely difficult to forecast commodity prices. For example, to trade corn futures, you need insight into next year’s weather patterns and global supply and demand trends—things that most retail investors lack.

(1) Commodity ETFs. Better options for most investors are exchange-traded funds (ETFs) that hold only commodities. ETFs are like mutual funds but offer the convenience of being publicly traded.

The largest and most liquid broad-basket commodity ETF is PowerShares DB Commodity Index Tracking Fund (NYSE: DBC). This fund is designed for investors who want a cost-effective and convenient way to invest in commodity futures (see the Investing Daily article A Basket of Commodities in a Single ETF for more on this fund).

Other ETFs track a narrower band of commodities. For example, SPDR Gold Trust (NYSE: GLD) has enabled the retail investor to take advantage of the yellow metal’s prolific bull run, while the United States Metals Index Fund (NYSE: USMI) gives exposure to a basket of metals by holding 10 metal futures contracts including gold, silver, platinum, palladium, aluminum, zinc, copper, nickel, lead and tin.

(2) Commodity stocks. The stocks of commodity producers, such as mining or agricultural companies, are also worth a look. Such equities are leveraged to moves in the price of the commodity, but in a much more limited way than futures contracts. Many commodity stocks also pay dividends, which is one of the surest ways to build long-term wealth in the stock market.

You can uncover our top commodities and commodity stock picks by checking out the free research report: Investing in Commodities: The 9 Commodity Stocks on the Verge of Breaking Out.

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