Commodities Trading: What Is It and Is It Right for You?

What is commodities trading?

Commodities trading is the buying and selling of raw materials like corn, oil, and metals. Sometimes it involves physically exchanging goods, but more often it happens through futures contracts, where you agree to buy or sell a commodity at a set price on a specified future date.

Commodities can add diversification to a portfolio and act as an inflation hedge, but they're highly volatile. Factors like weather events and political instability that are difficult to predict can have an outsized impact on prices.

How futures contracts work

Futures contracts are the most common way commodities are traded, and they serve two different purposes depending on who's using them.

Producers and industrial consumers use futures as a risk management tool. Say you're a corn farmer who wants to lock in the current market price for your crop. You sell a futures contract agreeing to deliver 5,000 bushels at $4 each in 90 days. If prices fall, you've protected yourself. If prices rise to $5, you miss out on the upside but had certainty when you needed it. On the other side, a food processing company that needs corn to make cornmeal might buy that same contract to protect against a price spike.

Investors and speculators use futures to bet on price direction. If you buy that futures contract with no intention of taking delivery of 5,000 bushels of corn, you're simply betting prices will rise so you can sell the contract at a profit. If you think prices will fall, you take a short position.

Futures contracts are typically traded on commodity exchanges. The two largest in the U.S. are the Chicago Mercantile Exchange and the New York Mercantile Exchange.

Commodities vs. the stock market

Commodity prices often fluctuate wildly because of changes in supply and demand. For example, when there's a big harvest of a certain crop, the price usually goes down. When there's a drought, prices often rise because of fears that the supply will drop.

Similarly, during cold weather, demand for natural gas for heating purposes rises. This causes prices to spike, too. But a warm spell during winter can depress prices.

Still, some commodities are relatively stable, such as gold, which also serves as a reserve asset for central banks. But in general, commodities are significantly more volatile than stocks or bonds. 

Some investors seek out commodities for diversification. Commodities usually have a negative correlation (their prices move in different directions) or a low correlation (their prices don't move in tandem with each other) with equities.

For example, oil and stocks tend to have a negative correlation. That means rising oil prices have traditionally been linked to a weaker stock market. Likewise, the stock market is often stronger when oil prices are low.

For that reason, commodities are a popular stock market hedge. Many investors flock to gold during a bear market, for example. Commodities are also a common inflation hedge. High inflation often causes commodity prices to soar; stocks and bonds perform better when inflation is lower.

How to invest in commodities

Commodity trading isn't the only way to invest in commodities. Here are four basic ways.

1. Invest directly in the commodity

The most straightforward way to invest in commodities is by physically buying a commodity. One advantage is that you don't have to go through a third party. Typically you can do a simple internet search to find a dealer to sell you a particular good. When you no longer want it, that dealer will often buy it back. But you have to figure out delivery and storage logistics.

If you're buying gold, this may be relatively simple. You can easily find a coin dealer online who can sell you a bar or coin. You can safely store it and later sell it as you wish. 

But it gets a lot harder when you're trying to figure out delivery and storage of cattle, crude oil, or agricultural commodities, like bushels of corn. For that reason, investing in most physical commodities typically takes too much effort for individual investors.

2. Invest in futures contracts

You can trade commodity derivatives, such as futures contracts, as long as you have a brokerage account that allows for it. But futures contracts are largely designed for major companies involved in commodities rather than for individuals.

When you trade futures, you'll be required to maintain a certain amount of capital, known as margin, in your brokerage account. One risk of trading commodities is that the margin requirements are often lower than for stocks.

When you trade on margin, you're trading borrowed money, which can amplify your losses. Given the volatility of commodity prices, it's essential to have enough resources on hand to cover any margin call, which is when your broker requires you to deposit more money.

3. Invest in commodity stocks

Another way to invest in commodities is to buy shares of the companies that produce them. For example, you could buy metal stocks, energy stocks, or meat stocks. 

A commodity-producing company won't necessarily rise or fall in line with the commodity it produces. Sure, an oil production company will benefit when crude oil prices rise and suffer when they fall. But far more important is how much oil it has in its reserves and whether it has lucrative supply contracts with high-demand purchasers. 

4. Invest in commodity ETFs and mutual funds

Commodity exchange-traded funds (ETFs) and mutual funds offer commodity exposure for those who don't want to buy the commodity directly. You can find an investment fund that invests in physical materials, commodity stocks, futures contracts, or a combination. 

For example, investors who want broad exposure to gold could invest in the SPDR Gold Trust ETF (GLD +2.70%), while those who are bullish on oil prices could buy shares of the United States Oil Fund LP (USO +0.06%). If you want more exposure to commodities in general, you could invest in the iShares S&P Commodity-Indexed Trust (GSG +0.16%). The fund's benchmark index is the S&P GSCI, which includes 24 commodities from all commodity sectors. 

However, commodity funds may not move in sync with the price of the underlying good. That may come as a surprise to new investors.

Should you trade commodities?

Commodity trading is high risk and high reward. It can be an effective hedge against inflation or a bear market, but it requires a strong understanding of supply-and-demand dynamics, historical price trends, and real-time market conditions.

Much of commodity trading is speculation rather than investing. Unpredictable events like weather, disease, and natural disasters can move prices sharply in the short term. For most individuals looking for long-term exposure, commodity stocks, mutual funds, and ETFs are a more practical and manageable approach than trading futures directly.