If you are even broadly familiar with investing then you’ve probably seen the term “commodity” tossed around. Understanding what commodities are and how they can help investors secure big returns is an important thing for anyone who is serious about investing. Even if you have another preferred type of investment, such as real estate or stocks, you should still give commodities a close look and at least be aware of how commodity markets work.
So what is a commodity anyways? At the most basic level a commodity refers to anything that can be bought or traded, but is interchangeable with any other commodity of the same type. Commodities are often used as inputs to produce other products. That’s a mouthful, isn’t it? Let’s use some examples to explain what commodity is.
Gold As a Commodity and A Product
Gold can be a commodity, under certain conditions. “Raw” gold of a particular quality and grade, for example, is a commodity. Gold shaped into a ring or even a bullion coin, however, is generally seen as a product. Still not making sense? Let’s take a moment to flesh out the difference between a product and a commodity.
Think of it this way, a jeweler needs gold as an input to produce his rings and other pierces of work. The jeweler won’t generally care where the “raw” gold input came from or what “brand” it is. As long as the gold is of a particular quality and purity, say 24 carrot, the jewelry maker really won’t care about other details.
A person buying a ring, however, will care a lot about the different rings he or she is choosing between. Even if every ring uses the same amount and quality of gold and inputs, they will not be interchangeable. Every person has particular tastes, and the craftsmanship put into making each ring can make a huge difference.
The same could even be said of bullion coins. A bullion coin is a lot like a commodity in that individual bullion coins are largely interchangeable. For example, American Eagle Gold Bullion coins of the same weight and purity generally hold the same value as each other. A gold coin from the New Zealand Mint and the U.S. Mint, however, can have a different value even if they are of the same weight and purity. Why? People sometimes trust one mint more than the other.
Conceptualizing Commodity Trading
Some people prefer trading commodities to stocks. Why? There are a lot of reasons, but there are some basic things to consider. Generally speaking, a single event, such as an accounting scandal, are less likely to have an impact on commodities. Commodities, instead, are more subject to global trends and demand.
The most obvious example of this is the price of oil. As the economy grows, more oil is needed to support the growth and development of industries and consumption of consumers. Factories and individuals will be consuming more energy when economies are growing. So demand for oil tends to rise during periods of expansion. This means that oil prices will generally trend upwards.
During an economic downturn, however, demand for oil tends to drop as production slows and people begin to try to conserve money. And what does basic economics teach us about slumping demand? It will lead to slumping prices. So during a period of economic contraction, oil prices often drop.
Of course, things can never be that simple. Anything that affects supply and demand can have big impacts on demand for oil, or any other commodity for that matter. For example, if sanctions are suddenly lifted on a major oil producing nation, such as Iran, that has been restricted from trading, the supply of oil entering the market will suddenly increase. This will usually lead to prices trending downwards.
If you are looking to get involved in commodities trading, it is important to pay close attention to world markets and any events that could affect supply and demand. Trading in commodities can produce big profits, but markets can be turbulent, and that can mean big losses. So make sure you carefully weigh the risks and upsides of each trade.