What are commodities?

Commodities are physical assets. Unlike stocks, indices or currencies, they're raw materials that are mined, farmed or extracted from the earth.

To be officially tradable, a commodity must be entirely interchangeable with another commodity of the same type, no matter where it was produced, mined or farmed.

For example, to a commodity trader, gold is gold. It doesn't matter where it was extracted. An ounce of gold mined in Australia is worth exactly the same amount as an ounce of gold mined in China, the USA or Tanzania.

The same can be said of other commodities such as natural gas, cotton and copper, so long as they meet certain minimum quality or purity standards.

Economists call this being fungible – it means large quantities of commodities can be traded quickly and easily on an exchange. This is because every trader can be confident they are buying/selling equivalent assets without needing to inspect them, or find out where or how they were produced.

Types of commodities

Commodities are often placed into two groups:

Soft commodities

These are agricultural commodities, farmed rather than mined or extracted. Softs tend to be very volatile in the short term, as they're susceptible to seasonal growing cycles, weather and spoilage which can suddenly and dramatically affect prices.

Hard commodities

These are generally mined from the ground, or taken from other natural resources. Hard commodities are typically easier to handle and transport than softs, and are more easily integrated into the industrial process.

You may also see commodities classified according to their ecological sector:

• Energy (oil and gas)
• Metal (gold, silver, copper, lead, etc.)
• Agriculture (wheat, coffee, livestock, etc.)

Energy commodities – such as oil and gas – are especially important in the Middle East, where production levels can influence both local and global markets.

How are commodities traded?

There are two main ways to trade commodities:

The spot market

The spot market is where financial assets are sold for cash and exchanged right away. So, if you need immediate delivery of a commodity, you'd head to the spot market.

For example, say you ran a business that built industrial pipes. You recently got an order for a large amount of copper piping, but there's none left in the warehouse. You need the copper immediately, so your best bet is to go to the spot market and buy some.

Similarly, if you owned a mining company and had some copper you wanted to get off your hands straight away, you'd try and sell it on the spot market.

Due to the large quantities of commodities traded – and the global nature of these trades – set standards are used so traders can buy and sell quickly without visual inspection.

The futures market

The futures market is a place where buyers and sellers agree to exchange a specific quantity of an asset at a fixed date in the future, at a price agreed today.

The assets in question are not physically traded on the exchange, so the participants buy and sell futures contracts instead. This enables traders and investors to take a view on commodity prices without owning the physical asset, since the contracts can be sold or closed before the delivery date.

Which is particularly useful if, for example, you want to trade on the price of cattle, but don't want several herds of live cows delivered to your door in a few months' time...

While futures contracts are often used by individuals and companies looking to exchange physical commodities at a later date, they are predominantly used for speculation and hedging.

Futures contracts work by tracking the spot price of an underlying market and taking other factors into account, such as volatility, the time until delivery, interest rates and the costs of maintaining a position – known as the cost of carry.

Futures prices are often higher than the spot price as it adds in all these factors. In this circumstance, the market is said to be in contango. Alternatively, when futures prices are lower than the spot price, the market is in backwardation. When a futures contract expires, it will be equal to the spot price.

Who trades commodity futures?

There are four main types of commodity futures trader.

Producers

These are companies/individuals that produce or extract commodities and enter into a futures contract to offset the risk of future price movements. If, for example, you are a coffee farmer, and agree to sell your yield for a specific price on a specific date, you will have a guaranteed income on that date even if coffee prices plummet in the meantime.

Speculators

These are traders looking solely to profit on commodity price movements. They generally have no interest in owning the physical commodity itself.

Hedgers

These are mid- or long-term investors who hold commodities in their portfolio to provide protection against downward movements in other securities. Commodities tend to move in an opposite direction (or at least an unconnected direction) to certain stocks and bonds.

In the event of a stock market crash, for example, investors holding commodities may not suffer as badly as those with exclusively stock-based portfolios. Gold in particular is seen as a 'safe haven' and receives significant investment when equities are unstable.

Brokers

These are firms or individuals who buy and sell commodity contracts on behalf of their clients.

Commodity markets can move quickly based on supply, demand and global events. A demo account lets you follow these price movements in real time and see how different commodities react to changing conditions – all with virtual funds.