How Commodities Function in the Market

Commodities are the raw inputs used in the production of goods. They may also be basic staples such as certain agricultural products. The important feature of a commodity is that there is very little differentiation in that good, regardless of who produces it. A barrel of oil is basically the same product, regardless of the producer. The same goes for a bushel of wheat or a ton of ore. By contrast, the quality and features of a given consumer product will often be quite different depending on the producer (e.g., Coke vs. Pepsi).1

Some traditional examples of commodities include grains, gold, beef, oil, and natural gas. More recently, the definition has expanded to include financial products, such as foreign currencies and indexes.

Commodities can be bought and sold are traded as financial assets on special exchanges. You can also buy contracts in well-developed derivatives markets, such as oil forwards, wheat or gold futures, and natural gas options). Some experts suggest investors include commodities in a diversified portfolio because they don't closely track other assets and can hedge against inflation.2

Commodity Buyers and Producers: Roles and Strategies

Commodities are typically bought and sold through futures on exchanges, which set standard quantities and quality. For instance, the Chicago Board of Trade (CBOT) defines a wheat contract as 5,000 bushels and specifies acceptable wheat grades.3

There are two types of traders in commodity futures. The first type, buyers and producers, use futures to hedge risks. They either deliver or receive the actual commodity when the futures contract ends.

For example, the wheat farmer who plants a crop can hedge against the risk of losing money if the price of wheat falls before the crop is harvested. The farmer can sell wheat futures contracts when the crop is planted and have a guaranteed, predetermined price for the wheat when it is harvested.

The Role of Speculators in Commodities Trading

The second type of commodities trader is the speculator. These traders aim to profit from price changes and don't plan to receive or deliver the commodity once the futures contract expires.

Many futures markets are very liquid and have a high degree of daily range and volatility, making them very tempting markets for intraday traders. Many index futures are used by brokerages and portfolio managers to offset risk. Also, since commodities do not typically trade in tandem with equity and bond markets, some commodities can be used effectively to diversify an investment portfolio.

Key Factors Influencing Commodity Prices

Commodity prices typically rise when inflation accelerates, which is why investors often flock to them for their protection during times of increasing inflation—particularly when it is unexpected. So, commodity demand increases because investors flock to them, raising their prices. The prices of goods and services then go up to match the increase. This causes commodities to often serve as a hedge against a currency's decreased buying power when the inflation rate increases.45

The Bottom Line

Commodities are basic goods that are interchangeable with others of the same type and serve as inputs for the production of goods and services. There are generally two types of commodities: hard, which include metals and energy products, and soft, which comprise agricultural products.

Commodities are traded on exchanges in spot markets and serve as underlying investments for futures and options contracts. Producers use commodities as a hedge against inflation, and speculators use them as a way to achieve further portfolio diversification.

Commodity prices are driven by prevailing economic factors such as inflation and follow the dynamics of supply and demand.