Commodities

What are commodities?
Commodities are goods which have no differentiation between them and which are identical no matter who produces them. For example, 24 carat gold is the same whether it is mined in South Africa, India or China. It is impossible to tell the difference between two barrels of Brent crude. Therefore, at any given point of time, two different barrels of Brent crude should sell at the same price, and so should 2 different bushels of wheat or 2 different ounces of gold.

Commodities could be precious metals such as gold and silver, base metals such as lead, softs such as coffee or energy related such as crude oil etc. Even complex instruments such as options on freight contracts or weather are traded frequently.

How can one trade in commodities?
Commodities are traded on commodity exchanges such as the Chicago Board of Trade (CBOT) or the Singapore Commodity Exchange (SICOM). The bulk of the commodity trading is done through derivatives such as Futures and Options. A commodity future is a contract that gives the buyer the right and the obligation to buy or sell a certain quantity of that commodity at a particular price after a particular period of time.

A commodity option gives the buyer the right but not the obligation to do the same. These futures and options can in turn, be traded. Traders can also trade in commodities without using futures or options. For example, I could buy 1 ton of cotton at X dollars and sell it a day later for a profit.

How can individual investors trade commodities?
It is not easy for small investors to trade commodities in general. Investors wanting exposure to oil or gold prices can trade Exchange Traded Funds (ETFs) that track the spot price of gold/oil such as the Benchmark Gold ETF (Gold) or the Macro Shares Oil Up ETF (Oil). Investors have to use options or futures traded on exchanges to get exposure to the prices of other commodities.

Many investors who would like large exposures to commodity prices in a passive manner use collateralized futures positions. This involves the purchase of treasury bills or bonds and the simultaneous entering into a futures contract on the buy side. This position can be rolled over indefinitely as long as the collateral is sufficient to maintain the required maintenance margin.

Commodities are not well correlated with equities and could thus provide valuable diversification benefits.

Next: Futures