The Basics of Commodities Investing

By Dirk Diggler , last updated December 22, 2011

Commodities are goods such as corn, grain, metals and other easily interchangeable products, what follows are the basics of investing in commodities. The interchangeable aspect of commodities is what makes them unique. When you purchase a commodity, it should not matter which producer you obtain them from because they should be essentially the same good. Unlike DVD players, which can vary from Sony to LG, a bushel of corn from one farmer should be equal to a bushel of corn from another farmer. The ways in which you can actually invest using commodities markets is discussed below.

Futures Contracts

The most popular investment strategy for those looking into the commodities market is what is called futures contracts. A futures contract is essentially a promise to purchase a certain amount of a commodity at a decided upon date. Most of the time, commodities investors will obtain these in order to secure a price, which protects them against price fluctuations later when the transaction is processed. This form of commodity investment strategy is popular among large commercial firms that use the specific commodity in their production process. Instead of being at the mercy of supply or demand shocks, they already know how much they will pay for a commodity good down the line. This is especially useful for a large tortilla chip company. They will lock in a certain amount of corn at a specific price to make sure they always a supply of corn to make their chips. If they invest in the commodity ahead of time, they can structure their other expenditures and prices around their supply. Another relevant example is the airline companies, which consume energy commodities such as natural gas and crude oil on enormous scales. Instead of paying a lot of extra money in a few months due to a rapid price change, they know exactly how much they will spend for a certain amount of natural gas or crude oil down the line. This is a safer play for these companies, because they would rather over pay a little now, than be forced to pay potentially huge prices later on.

Speculators

The other group that utilizes commodities markets is speculators. Commodities speculators are usually individual investors who purchase commodities with the intent of selling them at higher prices. A speculator does not purchase a commodity such as crude oil and expect to have 1000 barrels of crude oil to show up at their house in 3 months. Instead, they sell the commodity to a firm or another speculator before their investment matures. The commodities market is a highly volatile one, and is not for the inexperienced. When investing in the commodities market, people usually leverage their position and invest very large sums of money. This is done in the hopes that the commodity’s price rises just a small fraction before the contract matures. Even the most veteran investors will sometimes lose big on these risky investments, therefore it is important to hedge your position. One way you can hedge your investment is by looking into commodities that come with options. These options will protect you from enormous price fluctuations, but will cut into your investment too. Any safe investment strategy is going to come with a smaller rate of return, otherwise it wouldn’t be safe. Always consult a professional before investing in commodities. Beginners may want to look into an experienced commodity fund before making the jump on their own.

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