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Created on 25.07.2018 | Updated on 27.08.2019

Trading in commodities – how does it work?

You will almost certainly have heard of investing in commodities and trading in them. But what are commodities exactly? And how do you invest in them? We explain the basic principles.

There are many different types of commodities – with crops, livestock, soya, coffee, timber, rubber, cotton, gold, silver, copper, oil, natural gas and coal, investors have a wide range of options open to them when it comes to investing in commodities. While commodities usually refer to precious metals or oil and gas, the definition of commodities on the stock exchange is much broader – electricity and orange juice, which do not correspond with the common perception of commodities, are also traded on the stock exchange. Opinions differ over what exactly constitutes a commodity. The following graphic provides an overview of the main types of commodities in which you can invest, broken down into soft and hard commodities.

The diagram illustrates the different types of commodity in a flow chart. The word “commodities” is at the top, represented by a planet icon. This splits into two branches, specifically “Soft commodities” and “Hard commodities”. “Soft commodities” are divided up into Agriculture (represented by a tree icon) and Animals (represented by a pig icon). Animals include cattle, beef cattle, pigs and pork bellies. Agriculture is divided up into Softs and Crops. Examples of Softs are cotton, coffee, cocoa, orange juice, rubber, sugar, wood and wool. Examples of Crops are wheat, maize, soya, rice, oats, rye, barley, millet and rapeseed.  “Hard commodities” are divided up into Metals (represented by a gold bar icon) and Energy (represented by a Gas icon). Energy includes petroleum, petrol, natural gas, fuel oil, coal and electricity. Metals are divided up into Industrial Metals and Precious Metals. Industrial Metals include aluminium, copper, lead, mercury, nickel, tin, zinc and titanium. Precious Metals include gold, silver, platinum, iridium, palladium, osmium and ruthenium.

Purchasing commodities enables investors to diversity their investments and to safeguard their assets against rising inflation. Find out more about diversification in the article “Diversification- explained using examples”.

Commodity prices rise and fall in different cycles to shares on the financial markets, for example. When the economy slows down, demand for raw materials – such as tangible assets like gold – often rises. This automatically offsets inflation if there is turbulence on the financial markets. However, some commodities are affected by climatic factors, such as the weather or natural disasters – long periods of drought, for example, have an impact on the supply of plant-based commodities. Any decline in the purchasing power of money, such as on the capital markets, has an effect on currencies. In contrast, this does not affect commodities.

What approach should be adopted when investing in commodities?

Commodities are often traded with futures. Futures are foreign exchange forward contracts – in other words agreements to buy or sell a certain quantity of commodities on a particular date in future for a price set now. Futures are traded at specialized commodities futures exchanges. Physical delivery of goods, such as pork belly for example, often takes place upon expiry of a future. As this is not of interest to most private investors, there are also investment funds and ETFs in the field of commodities.

Commodities funds also allow investors to invest in commodities via the futures market. Such funds invest money in commodities futures via derivates and enable a simple form of diversification in various commodities and segments.

Precious metals (such as gold and silver) are commodities which can be physically bought directly. They are usually available in relatively small amounts, such as in the form of coins or bars. Precious metal accounts and gold funds provide an alternative for you to invest in silver and gold without having to physically buy the metal. To find out more about purchasing gold, see the article “When is it worth investing in gold and silver?”.

Finally, investors can also buy shares in commodities companies. Here investors “bet” on the commodities, but only indirectly, such as whether a rise or fall in the price of the commodity will also have an impact on the company concerned.

Investment in commodities is complex

With all of these options, you have to bear in mind that investing in commodities is a complex matter. Commodities are affected by completely different factors: energy and (industrial) metals depend on the global economy, whereas agricultural commodities are heavily influenced by the weather and good or bad harvests. The principle of only investing if you can properly assess the opportunities and risks also applies here. Investment in commodities does not generate any dividends or interest. It effectively implies betting on price trends. This is always quite speculative.

Do not disregard ethical considerations

Perhaps the most important aspect for many investors boils down to the ethical concerns when investing in agricultural commodities. Basic foodstuffs are also traded as commodities. While it has not been conclusively established if and to what extent commodities speculation drives up prices and thus makes staple foods unaffordable in developing countries, such considerations cannot simply be dismissed.

There is no lack of opportunity for investing in commodities. But think carefully about whether and which commodities fit in with your investment strategy and horizon and which instruments you would like to understand and use.

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