Why is it Risky to Invest in a Commodity? | 6 Things to Know Before You Start

Investors trade commodities on the futures markets. Investing in commodities carries a high risk due to the volatility in trading futures.

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We live in a world where there is a market for everything. Commodities are the everyday items and resources that our society depends on. Examples include:

  • Energy oil and natural gas
  • Metals silver, gold, and REMs (Rare Earth Metals)
  • Farm products meat, grains, coffee, and sugar
  • Technology Internet connection and mobile data

Everything from the chips in your computer to your morning coffee is made up of commodities. A good rule of thumb is:

If something is a mundane and abundant part of ordinary life it’s a commodity.

What Is a Commodity in Economics?
What Is a Commodity in Economics?

Commodity trading was the first form of trading as ancient civilizations exchanged food, precious metals, and other goods. Today, commodities trade on commodity-specific exchanges, like stocks or bonds. A famous example is the New York Board of Trade, a physical commodities exchange that includes many smaller ones, including the Coffee, Sugar, and Cocoa Exchange or CSCE. Another is the Chicago Mercantile Exchange or CME. Commodities exchanges are regulated by the Commodity Futures Trade Commission (CFTC), a US government financial regulatory body.

Commodities trading and investing have risks like any other asset, but they come with unique risks which we will cover in this article. Before we get there, it’s handy to know how commodities are different from other asset classes. Commodities are traded as futures contracts (i.e., futures) on futures markets, differing from how traditional assets such as stocks and bonds are traded.

Trading Commodities 101

Commodities are typically traded on futures markets. Terms like commodity futures, trading commodities, and invest in commodities refer to activities on the futures markets. An index that tracks a basket of commodities’ price movements and returns is called a commodity index and acts as an index fund in the stock market.

Futures Contracts (i.e., Futures)

A future is a pre-arranged contract between traders who agree to buy or sell a commodity at a price point at a specific time in the future. Buyers and sellers can do well in the right market conditions.

What are Futures? | aiSource
What are Futures? | aiSource

Commodities prices are highly volatile as prices fluctuate every day so trading them is speculative for both buyers and sellers.

Let’s say a producer works out a futures contract to sell a specified quantity of widgets at a set price point in the future. If the widget value rises, the buyer profits if they buy at the set price below its true market value. If the widget value falls, the seller profits if they sell at the set price above its true market value.

Another way to look at it is…

If the buyer buys below market value, they get a great deal and can resell the widgets and capture the margin. On the other hand, if the widget market has a downturn, the seller benefits from the guaranteed price bottom.

The set prices in futures create a level of guarantee for how much each buyer or seller stands to lose, helping each side understand its downside risk. This understanding creates stability in the markets and predictability in company operations for key production inputs which we will cover later.

Investing in Commodities Why Do It at All?

Despite the cyclical natures of the market, investing in commodities is a handy way to access unique benefits. The big three are:

1. Diversification

How to Diversify your Portfolio | Chase.com
How to Diversify your Portfolio | Chase.com

Investing in commodities and holding different asset classes in your portfolio is a great way to diminish the risk of one asset class and increase your odds of performing well in other market conditions. Where one asset succeeds, another will not.

For instance, in bullish times, stocks will perform well while bonds tend to underperform. In bearish conditions, stocks will plummet while bonds will rise. Investing in commodities is another way to diversify your holdings into a new asset class and reduce your overall portfolio risk.

Commodities usually perform the opposite of the stock market rising in value when the market is bearish. They hedge against market downturns as investors flock to assets like commodities that are unlikely to go out of demand. However, it is essential to keep portfolio allocation in mind, or else an investor can miss out on certain market conditions like the 10-year stock market bull run we just had.

2. Safety Net & Stability

Price Floor - Definition, Types, Effect on Producers and Consumers
Price Floor

A futures contract offers a guaranteed price bottom to the buyers, sellers, and investors of a contract. It also extends to the guarantee that a transaction will occur. This is a major difference between other assets like stocks or cryptocurrencies, which have the potential for large gains and losses but do not have fixed price floors. A price floor sets expectations for buyers who fear overpaying and sellers who fear large losses if the commodity’s value fluctuates up or down, respectively. Expectations breed stability, which translates into predictable input prices. Companies buy large quantities of commodities on futures markets as inputs for their supply chains (e.g., aluminum to create car parts). Through buying on the futures markets, companies avoid price volatility in their supply chains. Ultimately, this stabilizes end product pricing, which benefits everyday consumers like you and me.

This unique feature of the futures world offers stability and predictability not found in other asset classes, creating a limit to downside risk that is asymmetric compared to different asset classes.

3. Potential from Volatility

Profit Margins: Definition, Formulas and Examples - Consulterce

Despite the price floor in the commodity world, there is still a significant potential for profit due to price volatility. With volatility comes a high potential for growth as prices swing upward dramatically. This can create lucrative opportunities for savvy investors who know the market dynamics for a given commodity. Though this approach comes with high risk, many investors acknowledge the tradeoff and invest in commodities to exploit the potential for significant wins.

So Where Does the Risk Come From…?

Finally! An Alternative to Risk Matrices | Corporate Compliance Insights

As noted above, commodities are basic items or inputs into more complex products. A commodity’s quality and features do not vary much between producers, meaning that the apples I buy at one grocery store will be the same as the apples I can buy at another. This is a characteristic of a perfectly competitive market, where the product each producer sells does not vary from that of another producer. With many producers in the market, each one is a price taker, so no one firm sets the market price for that good. As a result, commodity performance is tied to the supply and demand forces of its market.

The risk comes from unanticipated events that disrupt either side of the forces and cause uncertainty. Risk factors include tech disruption, disasters, unexpected weather events, inflation, and geopolitical issues.

For instance, an increase in inflation, such as what the US is currently experiencing, will drive up food and meat prices, which would affect supply conditions. Other forces like tech disruption can greatly shock a given market or open up new opportunities. And geopolitics have an impact on global trade as actions like sanctions, embargoes, or tariffs can restrict the flow and supply of commodities, especially those that are inputs for more advanced goods like Rare Earth Minerals (REMs). In essence, commodities are risky because they are affected by events that are almost impossible to predict. The threat of disruption to key commodities in supply chains is often enough to bring nations to the negotiation table to work out their differences.

Invest in Commodities Getting into the Game

There are three main ways to get exposure to commodities:

1) Futures Contracts

Building on our discussion on futures above, we should note that futures are available for every tradable commodities category. Futures are the basis for the other two methods we will discuss below. The two types of investors that use futures contracts are institutions and speculators.

  • Institutional & Commercial Investors use futures as part of their budgeting processes to stabilize variable expense items and provide normality and runway to supply chain inputs. For instance, airlines use large amounts of fuel and use oil futures to secure large quantities of fuel at stable prices for a certain period of time to avoid price volatility. By using futures, airlines stabilize operating costs and ticket prices for passengers. Farmers also utilize futures to secure anticipated prices and profitability of the food they produce at harvest shielding them from the volatility in grain prices from when they plant seeds to when they harvest. It also protects them from unanticipated events such as a drought which affects crop yield. These investors use futures as hedges against price volatility to stabilize end product prices and supply chain spending.
  • Speculators are traders who buy futures and make short-term profits by exploiting price volatility. They make money by speculating on the contract price itself, not the underlying commodity. They never take delivery of the commodity as outlined in the contract.

The advantages to futures include more accessible analysis of the underlying commodity, ease of taking long or short-term positions, and profit potential from arbitrage on price volatility.

2) Exchange Traded Funds (ETFs)

Commodity ETFs offer baskets of futures for a specific commodity by tracking price movements. Investors can buy and trade ETF shares like stocks without having to own futures directly. This also means there are no management or redemption fees as the shares are treated like stock, saving investors transaction fees. Some ETFs will have physical custody of the commodity. Investors can hold an ETF and profit from price changes without owning a special brokerage account, which can be required for futures. However, ETFs sometimes do not reflect price movements for a commodity point for point. Advantages include ease of buying and selling, reduced volatility due to diversification, and indirect exposure to futures.

3) Mutual and Index Funds

Mutual funds can invest in companies involved with commodity-based industries such as agriculture, energy, and metals. However, a small number of mutual funds are based on commodity indexes and invest in the futures giving investors direct exposure. Note that mutual funds are affected by other factors besides commodity prices and are affected by stock market risks such as company-specific risks. Investors using mutual funds get the advantages of liquidity, professional management, and diversification though the professional managers incur higher fees.

A cheaper alternative is to invest in an ETF as mentioned above and hold other asset funds in your portfolio, providing diversification at a more affordable cost.

The Bottom Line

We walked through what commodities are and how they are traded as futures contracts. We also covered what the futures market is. We weighed the attraction of investing in commodities against the factors that make them risky. We also covered some of the easier ways to gain exposure to commodities, although other methods are available, each with its advantages and disadvantages. Like any financial decision, you should carefully do your research or consult a professional advisor to determine if it is the right to move for your situation.

We are not financial advisors. The content on this website and our YouTube videos are for educational purposes only and merely cite our own personal opinions. In order to make the best financial decision that suits your own needs, you must conduct your own research and seek the advice of a licensed financial advisor if necessary. Know that all investments involve some form of risk and there is no guarantee that you will be successful in making, saving, or investing money; nor is there any guarantee that you won't experience any loss when investing. Always remember to make smart decisions and do your own research!

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