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What are Commodities?

Updated: Mar 26, 2023



In this article, we will explore the fascinating world of commodities – the essential raw materials that make up the backbone of our daily lives. From the metals in our smartphones to the agricultural products that feed us, commodities play a critical role in the global economy. We'll dive into the different types of commodities, including metals, agricultural products, energy, and more. Along the way, we'll discuss the various factors that impact commodity prices, the key players in the commodity markets, and the difference between commodities and other financial instruments like securities or assets. So, grab a cup of coffee, sit back, and join us as we unravel the complex and intriguing world of commodities.



Definition of Commodity

A commodity is a basic good, usually a raw material, that is used in the production of finished goods or services. These goods are typically interchangeable with other similar goods and are uniform in quality, known as the basis grade.



What are commodities?

Commodities are the inputs required for the production of a wide range of goods and services. They are traded on both the spot market, where they are bought and sold for immediate delivery, and the derivatives market, where contracts are used to speculate on future price movements.



Types of Commodities

Commodities can be broadly categorised into two types: hard commodities and soft commodities.


Hard Commodities

Hard commodities are typically extracted or mined from natural resources, such as metals and petroleum products.


Soft Commodities

Soft commodities, on the other hand, are agricultural products or livestock, such as wheat, cotton, coffee, sugar, and soybeans.



Examples of Commodities

Commodities are abundant and include various types of goods:


Metals

These include precious metals like gold and silver, as well as industrial metals like copper and aluminium.


Agricultural Products

Wheat, corn, soybeans, sugar, and coffee are examples of agricultural commodities.


Energy

Crude oil, natural gas, and gasoline are examples of energy commodities.


Environmental Commodities

These are market-based instruments that represent a specific environmental attribute, such as carbon credits or renewable energy certificates (RECs). They are traded to help companies and governments comply with environmental regulations and promote the adoption of cleaner, more sustainable practices.


Livestock

This category includes animals raised for consumption, such as cattle, hogs, and poultry. Livestock commodities are typically traded in the form of futures contracts, which can be used by producers to hedge against price fluctuations or by speculators to bet on price movements.


Fibre

This category consists of commodities used in the production of textiles, such as cotton, wool, and silk. Fibre commodities are influenced by factors such as weather conditions, production levels, and global demand for textile products.


Chemicals

Chemical commodities include raw materials used in the production of various chemical products, such as plastics, fertilisers, and pharmaceuticals. Examples of chemical commodities include ethylene, propylene, and ammonia.


Forest Products

This category comprises commodities derived from trees and other plants, such as lumber, pulp, and paper. The prices of forest product commodities are influenced by factors like logging regulations, forest management practices, and global demand for wood and paper products.


Buyers and Producers of Commodities

Commodity buyers and producers use the markets to manage their exposure to price fluctuations. For example, a wheat farmer may use futures contracts to lock in a price for their crop, ensuring they have a stable income even if market prices change.



Commodity Speculators

Speculators participate in commodity markets to profit from price movements. They do not typically take physical possession of the commodity but instead use financial instruments like futures and options to trade. Their activities can contribute to volatile price movements but also provide liquidity to the market.



Special Considerations

Commodity markets can be volatile, but they offer several benefits to investors, including:


Volatility

While price fluctuations can be risky, they also provide opportunities for intraday trading and potentially high returns.


Diversification

Investing in commodities can help diversify a portfolio, reducing the overall risk.


Inflation Protection

Commodities can act as a hedge against inflation, preserving the buying power of investments.



Relationship between Commodities and Derivatives

Derivatives, such as futures and forward contracts, play a significant role in commodity markets. They allow buyers and sellers to manage risk, hedge against price fluctuations, and speculate on price movements.


Futures Contracts

These are standardised contracts to buy or sell a commodity at a predetermined price on a future date. They are traded on exchanges like the Chicago Board of Trade.


Forward Contracts

These are customised agreements between two parties to buy or sell a commodity at a specific price on a future date. Unlike futures contracts, forward contracts are not traded on exchanges and are less liquid.



Determinants of Commodity Prices

Several factors can influence commodity prices, including:


Supply and Demand

Changes in supply and demand can impact prices. For example, if demand for a commodity outpaces supply, prices may rise, and vice versa.


Economic Shocks

Events like recessions or periods of rapid economic growth can affect commodity prices, as they influence both supply and demand.


Natural Disasters

Droughts, floods, or other natural disasters can disrupt the production or transportation of commodities, leading to price fluctuations.


Investor Appetite

Investor sentiment and market speculation can also drive price changes in the commodity markets.



Difference between Commodity and Security or Asset

While commodities are physical products that are not consumed through use, securities or assets are financial instruments that represent legal rights or claims. Examples of securities include stocks, bonds, and options, while commodities are tangible goods like grains, metals, and energy products. Read more about the stock market here



Conclusion

Commodities are an essential aspect of the global economy, they impact everything from the price of goods and services to the stability of financial markets. By understanding the different types of commodities, how they are traded, and the factors influencing their prices, investors can make more informed decisions about including them in their portfolios.



FAQs

  1. What is the main difference between hard and soft commodities? Hard commodities are typically extracted or mined, such as metals and petroleum products, while soft commodities are agricultural products or livestock, like wheat, cotton, and coffee.

  2. How do futures contracts work in commodity trading? Futures contracts are standardised agreements to buy or sell a commodity at a predetermined price on a future date. They are traded on exchanges and help buyers and sellers manage risk and speculate on price movements.

  3. What factors influence commodity prices? Supply and demand, economic shocks, natural disasters, and investor appetite can all impact commodity prices.

  4. How can investing in commodities provide inflation protection? Commodities can act as a hedge against inflation because their prices often rise when the overall cost of goods and services increases, preserving the buying power of investments.

  5. What is the difference between a commodity and a security or asset? Commodities are physical products, while securities or assets are financial instruments that represent legal rights or claims. Examples of securities include stocks, bonds, and options, while commodities are tangible goods like grains, metals, and energy products.



 



About the Author



Spitty, the founder of Spitfire Traders, is a full-time crypto, forex, and stock trader with years of experience under his belt. His passion for trading led him to develop a successful career, and now, he is dedicated to sharing his knowledge with others as an educator. Spitty is a firm believer in confluence trading, focusing on technical analysis without relying on fundamentals or news events. He also steers clear of indicators and breakout strategies, emphasising the importance of price action and risk management.



As a seasoned trader, Spitty is committed to helping his students become consistently profitable full-time traders. Through Spitfire Traders, he offers a comprehensive course and mentorship program, providing the necessary tools and guidance for aspiring traders to succeed in the markets. With a no-nonsense approach to trading and a keen eye for spotting valuable opportunities, Spitty continues to inspire and support the next generation of traders on their journey towards financial freedom.


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