Introduction to Financial Basics: What are Commodities?

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In this Smart Money Club Financial Basics lesson, we will be talking about commodities. Commodities are physical assets; they differ from stocks, indexes, and currencies, which don’t have intrinsic value. Commodities are farmed, extracted, and mined and include:

  • Gold
  • Oil
  • Cattle
  • Wheat

To be a tradable commodity, it must be interchangeable with the same commodity no matter where it is produced (farmed/mined.) For the trader, gold is gold; whether it is produced in Canada, South Africa, or Australia, an ounce has an equal value.

All other commodities, such as natural gas, copper, and cotton, are similar and must meet minimum quality/purity standards; this quality is “fungible,” and this allows traders to be confident that the commodity can be bought and sold without the need for inspection or knowing their origin.

Quiz 1

Which of the following are commodities? (there is more than one correct answer)

  1. Oats
  2. Tin
  3. Sugar
  4. Plastic

Quiz answers are at the end of the lesson.

Types of Commodities

Commodities can be divided into two groups.

Soft Commodities

These are created through farming and agriculture rather than mined or extracted and have high volatility in the short term. Being susceptible to seasons, weather, growth cycles, and spoilage that can all affect the soft commodity’s price.

Hard Commodities

These are conversely mined or extracted from natural resources. Hards, being more easily transported and stored, have less volatility and can be integrated into industrial processes.

Ecological Sector

Another commodity classification system can be by the commodity’s ecological sector:

Energy-i.e., oil and gas

Metals-i.e., gold, copper, lead

Agriculture-i.e., coffee, pork, wheat

Quiz 2

  1. Is Orange Juice a hard or soft commodity?
  2. Is Brent Crude Oil a hard or soft commodity?
  3. Is Platinum a hard or soft commodity?
  4. Are Soybeans a hard or soft commodity?

How are commodities traded?

Commodities are traded in two general ways:

Spot Market

Where commodities are sold for cash with an immediate exchange. If you need the commodity delivered, you buy on the spot market.

You are a company that builds pipe and have a copper pipe order. Your supply is low, so you need to buy some today and go to the spot market to do so.

Likewise, if you own a copper mine and smelter and have produced copper for sale, you will sell it on the spot market.

There are global standards for the quality of these commodity purchases, so no visual inspection is required. 

Futures Market

This market is where buyers and sellers agree to a defined asset quantity on a fixed date in the future with an agreed price today.  

The commodities are not physically traded on this exchange, so participants buy and sell “futures contracts,” enabling them to speculate on commodity prices with no concern of ownership because the contract can be sold or closed before the delivery date arrives. This attribute of futures is beneficial if you want to trade pork bellies but don’t want them delivered to your home in a few months.

Futures can be used for the exchange of the commodity at a later date, but they are predominantly used to hedge, and the futures market differs from the spot market because the seller must account for future risk, holding/storage charges, and shipping to the end buyer. Therefore, futures use forward prices, not spot prices.

Who Trades Commodity Futures?

Producers

Companies or individuals producing the commodity enter into the contract to ensure a future selling price. A wheat farmer agrees to sell a certain number of bushels of wheat on a defined date at a designated price to guarantee an income on their crop even if the price of wheat falls. 

Speculators

These are traders looking to profit from the movement of a commodity price that generally have no intention to own the physical commodity.

Hedgers

Mid to long-term investors who will hold commodities, adding a balance to their portfolio to protect against downward movements in other assets like securities. Commodities will generally move in opposite directions to most stocks and bonds. 

Investors with commodities will be less impacted if the stock market crashes than an exclusively stock holding portfolio. Gold is seen as both a store of value and a safe haven when other parts of the economy are unstable.

Brokers

Firms and individuals who are buying and selling commodity contracts on behalf of their clients, which are generally smaller speculators and hedgers.

Summary

In this Smart Money Club lesson, we saw that commodities are assets that can be mined, extracted, or produced by agricultural means. Soft commodities are agricultural items, and hard commodities are assets like energy products and metals. Commodities are traded on both the spot and futures markets. The spot market is where the physical commodity is traded, while the futures market has many speculators and hedgers.

Let’s take our trading to the Power of X and see how trading of Commodities is done in our next lesson; CLICK HERE

Quiz 1

1, 2, and 3 are correct; plastic is not a commodity.

Quiz 2

  1. Orange Joice is a soft commodity
  2. Brent Crude is a hard commodity
  3. Platinum is a hard commodity
  4. Soybeans are a soft commodity

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