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Commodity: What It Is and How to Trade It

Adam Lienhard
Commodity: What It Is and How to Trade It

A commodity refers to a basic product used in commerce that can be easily interchanged with other goods of the same type. These goods are typically raw materials utilized in the production of finished goods or services. Commodities serve as essential inputs in the manufacturing process or as staple goods. Learn more about the commodity market to trade on Headway.

Key characteristics

In economics, commodities are considered economic goods, usually resources, that possess fungibility. Fungibility means that instances of the commodity are treated as equivalent or nearly equivalent in the market, irrespective of their specific source or producer. 

For instance, a barrel of oil or a bushel of wheat is essentially the same regardless of its origin. In contrast, consumer products often exhibit significant variations in quality and features based on the producer. Still, they must meet specified minimum standards when traded on exchanges.

Commodities hold a significant place among valuable asset classes, alongside stocks, bonds, real estate, and cryptocurrencies. These raw materials are part of our daily lives and directly impact the cost of groceries. 

Furthermore, commodities offer investment opportunities as they can be bought and sold in various markets. 

Two types of commodities

Commodities are generally categorized into two groups: soft and hard commodities. Soft commodities are typically grown or farmed, such as cotton or beef cattle. On the other hand, hard commodities are obtained through resource extraction, like mining, and include goods such as gold or oil.

Traditional examples of commodities include agricultural products like grains, livestock, and natural resources such as gold, oil, and natural gas. Industries spanning from clothing production (cotton) to airlines (oil) to packaged goods (plastics derived from coal, cellulose, salt, and crude oil) heavily rely on commodities.

However, the definition of commodities has expanded to encompass financial products like foreign currencies and indexes.

How to invest in a commodity

Investing in commodities carries higher risks compared to average investments due to price fluctuations influenced by unpredictable factors. Natural and man-made uncertainties like pandemics, epidemics, natural disasters, wars, and unusual weather patterns can impact supply and demand. For instance, the COVID-19 pandemic in 2020 caused oil prices to plummet due to travel and tourism restrictions.

There are several ways to invest in commodities. The most common methods include trading futures contracts, using exchange-traded funds (ETFs), employing Contract-for-Difference (CFD) instruments, or making direct purchases. Precious metals like gold and silver can be purchased directly, while goods like grains or oil are typically traded through futures contracts.

Commodity futures involve legal agreements between two parties, obliging them to fulfill a contract. For instance, one party may agree to sell a specific product, like barley, at a predetermined price in the future. The futures market facilitates the trading of assets such as metals, grains, and cotton, as well as US and foreign currencies.

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