Most people picture a trading floor at a futures exchange as a scene of utter chaos, with fierce shouting matches, frantic hand signals, and high-strung traders jockeying to get their orders executed, which is not too far from the truth. These markets are where buyers and sellers come together to trade an ever-expanding list of commodities. That list today includes agricultural goods, metals and petroleum, and products such as financial instruments, foreign currencies, and stock indexes that trade on a commodity exchange.
At the center of this supposed disorder are products that offer a haven of sorts—a hedge against inflation. Because commodities prices typically rise when inflation is accelerating, they offer protection from the effects of inflation. Few assets benefit from rising inflation, particularly unexpected inflation, but commodities usually do. As the demand for goods and services increases, the price of goods and services rises as does the price of the commodities used to produce those goods and services. Futures markets are thus used as continuous auction markets and as clearinghouses for the latest information on supply and demand.
Key Takeaways
- Commodities are produced or extracted products, often natural resources or agricultural goods, that are often used as inputs into other processes.
- Allocating some of your portfolio to commodities is recommended by many experts as it is seen as a diversifier asset class.
- Moreover, some commodities tend to be a good hedge against inflation, such as precious metals and energy products.
What Are Commodities?
Commodities are goods that are more or less uniform in quality and utility regardless of their source. For instance, when shoppers buy an ear of corn or a bag of wheat flour at a supermarket, most don't pay much attention to where they were grown or milled. Commodity goods are interchangeable, and by that broad definition, a whole host of products where people don't particularly care about the brand could potentially qualify as commodities. Investors tend to take a more specific view, most often referring to a select group of basic goods that are in demand across the globe. Many commodities that investors focus on are raw materials for manufactured finished goods.
Investors break down commodities into two categories: hard and soft. Hard commodities require mining or drilling, such as metals like gold, copper, and aluminum, and energy products like crude oil, natural gas, and unleaded gasoline. Soft commodities refer to things that are grown or ranched, such as corn, wheat, soybeans, and cattle.
Benchmarks for Broad Commodity Investing
Benchmarking your portfolio performance is crucial because it allows you to gauge your risk tolerance and expectations for return. More importantly, benchmarking provides a basis for a comparison of your portfolio performance with the rest of the market.
For commodities, the S&P GSCI Total Return Index is considered a broad commodity index and a good benchmark. It holds all futures contracts for commodities such as oil, wheat, corn, aluminum, live cattle, and gold. The S&P GSCI is a production-weighted index based on the significance of each commodity in the global economy, or the commodities that are produced in greater quantities, so it is a better gauge of their value in the market place similar to the market-cap-weighted indexes for equities. The index is considered more representative of the commodity market compared to similar indexes.
Why Commodities Add Value
Commodities tend to bear a low to negative correlation to traditional asset classes like stocks and bonds. A correlation coefficient is a number between -1 and 1 that measures the degree to which two variables are linearly related. If there is a perfect linear relationship, the correlation coefficient will be 1. A positive correlation means that when one variable has a high (low) value, so does the other. If there is a perfect negative relationship between the two variables, the correlation coefficient will be -1. A negative correlation means that when one variable has a low (high) value, the other will have a high (low) value. A correlation coefficient of 0 means that there is no linear relationship between the variables.
Typically, U.S. equities, whether in the form of stocks or mutual funds, are closely related to each other and tend to have a positive correlation with one another. Commodities, on the other hand, are a bet on unexpected inflation, and they have a low to negative correlation to other asset classes.
Commodities can and have offered superior returns, but they still are one of the more volatile asset classes available. They carry a higher standard deviation (or risk) than most other equity investments. However, by adding commodities to a portfolio of assets that are less volatile, the overall portfolio risk decreases due to the negative correlation.
For the decade 2011 through 2020, the annual performance of the S&P GSCI has been negative in seven out of ten years. Therefore, some investors have questioned the value of commodities in their portfolios and if commodities could continue to decline in the future.
How Volatile Are Different Commodities
Supply-and-demand dynamics are the main reason commodity prices change. When there's a big harvest of a certain crop, its price usually goes down, while drought conditions can make prices rise from fears that future supplies will be smaller than expected. Similarly, when the weather is cold, demand for natural gas for heating purposes often makes prices rise, while a warm spell during the winter months can depress prices.
Because the supply and demand characteristics change frequently, volatility in commodities tends to be higher than for stocks, bonds, and other types of assets. Some commodities show more stability than others, such as gold, which also serves as a reserve asset for central banks to buffer against volatility. Yet even gold becomes volatile sometimes, and other commodities tend to switch between stable and volatile conditions depending on market dynamics.
The History of Commodity Trading
People have traded various commodity goods for millennia. The earliest formal commodities exchanges are among those in Amsterdam in the 16th century and Osaka, Japan, in the 17th century. Only in the mid-19th century did commodity futures trading begin at the Chicago Board of Trade and the predecessor to what eventually became known as the New York Mercantile Exchange.
Many early commodities trading markets were the result of producers coming together with a common interest. By pooling resources, producers could ensure orderly markets and avoid cutthroat competition. Early on, many commodity trading venues focused on single goods, but over time, these markets aggregated to become broader-based commodities trading markets with a variety of goods in the same place.
How to Invest inCommodities
There are four ways to invest in commodities:
- Investing directly in the commodity.
- Using commodity futures contracts to invest.
- Buying shares of exchange-traded funds (ETFs) that specialize in commodities.
- Buying shares of stock in companies that produce commodities.
Direct Investment
Investing directly in a commodity requires acquiring it and storing it. Selling a commodity means finding a buyer and handling delivery logistics. This might be doable in the case of metal commodities and bars or coins, but bushels of corn or barrels of crude oil are more complicated.
Futures
Commodityfutures contractsoffer direct exposure to changes in commodity prices.Certain ETFs also offer commodity exposure. If you would rather invest in the stock market, you can trade stock in companies that produce a given commodity.
Commodity futures contracts require the investor to buy or sell a certain amount of a given commodity at a specific time in the future at a given price. To trade futures, investors require a brokerage account or a stockbroker who offers futures trading.
When prices of a commodity rise, the value of a buyer's contract goes up while the seller suffers a loss. Conversely, when the price of a commodity goes down, the seller of the futures contract profits at the expense of the buyer.
Futures contracts are designed for the major companies in the respective commodity industry. One gold contract could require buying 100 troy ounces of gold, which could be a $150,000 commitment, which is more exposure than the average investor wants in their portfolios.
ETFs
Most individual investors choose ETFs with commodity exposure. Some commodity ETFs buy the physical commodities and then offer shares to investors that represent a certain amount of a particular good.
Some commodity ETFs use futures contracts. However, futures prices take into account the storage costs of a given commodity. Therefore, a commodity that costs a lot to store might not show gains even if the spot price of the commodity itself rises.
Commodities-Related Stocks
Investors can also buy shares of the companies that produce commodities. For example, companies that extract crude oil and natural gas or companies that grow crops and sell them to food producers. Investors in commodity stocks know that a company's value will not necessarily reflect the price of the commodity it produces.
What is most important is how much of the commodity the company produces over time. The price of a stock can plummet if a company does not produce what the investors have anticipated.
Why Are Commodities Considered an Inflation Hedge?
Inflation is a general rise in prices. Commodities tend to be inputs into manufacturing processes or consumed by households and businesses. As a result, when prices rise in general, so should commodities. Traditionally, gold has been the exemplar inflation-hedge commodity.
How Do Commodities Diversify a Portfolio?
Portfolio diversification occurs when uncorrelated risky assets are added to it. Because commodities, on average, have low or negative correlations with stocks and other asset classes, they can provide some diversification.
What Are Hard vs. Soft Commodities?
Hard commodities are usually classified as those that are mined or extracted from the earth. These can include metals, ore, and petroleum products. Soft commodities instead refer to those that are grown, such as agricultural products.
What Percentage of My Portfolio Should Be in Commodities?
Experts recommend around 5-10% of a portfolio be allocated to a mix of commodities. Those with a lower risk tolerance may consider a smaller allocation.
The Bottom Line
During inflationary times, many investors look to asset classes like real-return bonds and commodities (and possibly foreign bonds and real estate) to protect the purchasing power of their capital. By adding these diverse asset classes to their portfolios, investors seek to provide multiple degrees of downside protection and upside potential. What is important is that the investor draw the line on the maximum correlation of returns they will accept between their asset classes and that they choose their asset classes wisely.
FAQs
Hedging is a future commitment to buy or sell a set quantity of a commodity at a set price. By creating this future contract, manufacturers ensure they get the commodities they need for production and sellers know they have a buyer for crops they are growing.
What is commodity hedging? ›
Hedging is a future commitment to buy or sell a set quantity of a commodity at a set price. By creating this future contract, manufacturers ensure they get the commodities they need for production and sellers know they have a buyer for crops they are growing.
What are the commodities in a portfolio? ›
Types of commodity investments
Energy includes oil, natural gas, and more. Metals include precious metals like gold, but also industrial metals like aluminum and copper. And soft commodities include agricultural products like grains, livestock, and coffee.
Are commodities a good hedge? ›
Moreover, some commodities tend to be a good hedge against inflation, such as precious metals and energy products.
What are examples of commodity hedging? ›
A hedge is an investment made to reduce the risk of adverse commodity price movements. Typically, your hedging strategy takes an offsetting position in a derivative or a related security. For example, the run-up in agriculture products might induce you to sell your crops ahead of the harvest.
What are the biggest hedge funds commodities? ›
The Top Commodity Hedge Funds, Trading Firms, and Trading Desks. All the large, multi-manager hedge funds use global macro strategies, and some have dedicated commodity groups. So, expect to see commodity traders at the likes of Citadel, Millennium, Balyasny, Squarepoint (quant focus), DRW (quant), and DE Shaw (quant).
What are the three types of hedging? ›
The three types of hedge accounting remain: cash flow; fair value and net investment hedges.
What are 7 types of commodities? ›
Major commodities include cotton, oil, gas, corn, wheat, oranges, gold, and uranium.
What are 3 examples of commodities? ›
Commodities include agricultural products such as wheat and cattle, energy products such as oil and natural gas, and metals such as gold, silver and aluminum. There are also “soft” commodities, or those that cannot be stored for long periods of time, which include sugar, cotton, cocoa and coffee.
What are the 4 commodities? ›
Types of Commodities
Commodities that are traded are typically sorted into four categories broad categories: metal, energy, livestock and meat, and agricultural.
Energy Crisis Sets Coal on Fire
| Rank | Commodity | 2022 Returns |
|---|
| #1 | Coal | 157% |
| #2 | Lithium | 87% |
| #3 | Nickel | 43% |
| #4 | Titanium | 27% |
6 more rowsJan 15, 2023
Three of the most commonly traded commodities include oil, gold, and base metals.
What commodities to hedge against inflation? ›
Commodity futures portfolios provide the instruments needed to hedge against different types of inflation. Energy futures perform well during energy-driven cost-push inflation; industrial metals during demand-pull inflation; and precious metals, especially gold, perform well when central bank credibility is questioned.
How do commodity traders hedge? ›
They normally hedge physical commodity transactions with derivatives. Hedging exchanges flat price risk for basis risk. The basis is the differential between the price of a physical commodity and its hedging instrument. Basis risk is the risk of a change in this differential.
What are the benefits of commodity hedging? ›
The benefit of commodity hedging is greater certainty – think of it as a form of insurance. Every hedging strategy has a cost, whether you are hedging cobalt or lithium, hedging aluminum, hedging energy, or hedging steel.
What are examples of commodity investments? ›
Commodity funds invest in raw materials or primary agricultural products, known as commodities. These funds invest in precious metals, such as gold and silver, energy resources, such as oil and natural gas, and agricultural goods, such as wheat.
What is the most profitable hedge fund strategy? ›
Top hedge funds follow Equity Strategy, with 75% of the Top 20 funds tracking the same. Relative Value strategy is followed by 10% of the Top 20 Hedge Funds. Macro Strategy, Event-Driven, and Multi-Strategy make the remaining 15% of the strategy. Also, check out more information about Hedge Fund jobs.
What is the largest commodity ETF? ›
The largest Commodities ETF is the SPDR Gold Trust GLD with $59.08B in assets.
What is the greatest hedge fund of all time? ›
The ranking estimates that Citadel generated $16 billion in profits for its investors in 2022 and has accumulated $65.9 billion in net gains since its foundation in 1990. Despite Bridgewater's estimated net gains of $6.2 billion in 2022, Citadel overtook Dalio's fund to become the top gainer on the all-time list.
What are the 4 hedging techniques? ›
In short, the 4 main steps of a good hedging strategy are simple: take stock of your international financial situation, choose the strategy best adapted to your company and identify the corresponding financial products, and finally monitor your strategy in order to modify it if necessary.
Among needle-bearing evergreens, yew bushes are perhaps the most classic hedge plants. They are popular partly because they tolerate shade. While some yews grow tall enough to serve as privacy screens, yews are slow growers.
Which is the best hedging technique? ›
As a rule, long-term put options with a low strike price provide the best hedging value. This is because their cost per market day can be very low. Although they are initially expensive, they are useful for long-term investments.
What is the most traded commodity in the world? ›
Brent Crude oil is the most traded global commodity. Brent Crude is extracted from the North Sea and accounts for two-thirds of global oil pricing. Like the other crude oil benchmark WTI, Brent Crude is mainly refined into diesel fuel and gasoline.
What are 2 major commodities? ›
There are several commodities available. Energy products include crude oil, natural gas, and gasoline. Precious metals include gold, silver, and platinum. Agricultural products include wheat, corn, soybeans, and livestock.
What are 5 commodities? ›
California's Top 10 Agricultural Commodities
- Dairy Products, Milk — $7.57 billion.
- Grapes — $5.23 billion.
- Almonds — $5.03 billion.
- Cattle and Calves — $3.11 billion.
- Strawberries — $3.02 billion.
Crude Oil
Crude oil is the commodity with the highest trading volume. It is used for the extraction of petrol, diesel, and petrochemicals.
What are 5 commodities from the United States? ›
Midwest
- Corn.
- Soybeans.
- Wheat.
- Cattle & Calves.
- Swine.
- Dairy.
- Rice.
- Cotton.
How do commodities perform in recessions? Industrial metals are usually hit hardest, falling 35% peak-to-trough. Energy price spikes partly cause two-thirds of recessions, then typically trade back to pre-recession levels.
What are the six commodities? ›
Abu Sa'id al-Khudri (Allah be pleased with him) reported Allah's Messenger (may peace be upon him) as saying: Gold is to be paid for by gold, silver by silver, wheat by wheat, barley by barley, dates by dates, salt by salt, like by like, payment being made hand to hand.
Who are the big four commodity traders? ›
The first introduces the four big commodity traders – Archer Daniels Midland (ADM), Bunge, Cargill, and Louis Dreyfus – which are the focus of this study. Collectively, these trading companies are often referred to as 'the ABCD companies' because of the coincidence of their initials.
The Top 10 Commodities to Trade in 2023
- Gold. Gold is one of the most regularly-traded commodities and is a precious metal that is continually in demand. ...
- Silver. Another precious metal, as a commodity, silver shares many of the attributes of gold: ...
- Crude Oil. ...
- Natural Gas. ...
- Copper. ...
- Coffee. ...
- Soy Beans. ...
- Iron Ore.
Move over oil — natural gas is the hottest commodity in the world now.
What commodities are in high demand in the future? ›
While demand for some commodities like coal or oil is likely to plateau and decline, the demand for others is growing and looks set to rise. The renewable energy industry requires copper, lithium, cobalt, nickel, iron ore and silver. Digitalisation requires massive server farms and enormous quantities of energy.
Which commodity is best for inflation? ›
Commodities such as precious metals, agriculture goods, and oil & gas have often been touted as a portfolio diversifier that serves as a hedge against inflation.
What are the top 10 commodities in order? ›
The 10 largest sources of cash receipts from the sale of U.S.-produced farm commodities in calendar year 2021 were (in descending order): cattle/calves, corn, soybeans, dairy products/milk, broilers, hogs, miscellaneous crops, wheat, chicken eggs, and hay.
What commodities are trending? ›
Commodities news
| Commodity | Last price/ contract | Today's change |
|---|
| RBOB Gasoline As of Jun 10 2023 21:59 BST. | 2.60 USD | -0.0155 -0.59% |
| Heating Oil As of Jun 10 2023 21:59 BST. | 2.36 USD | -0.0256 -1.07% |
| WTI Crude Oil As of Jun 10 2023 21:59 BST. | 70.35 USD | -0.94 -1.32% |
| Natural Gas As of Jun 10 2023 21:59 BST. | 2.26 USD | -0.09 -3.83% |
2 more rowsCorn, soybeans, barley and oats
The largest United States crop in terms of total production is corn, the majority of which is grown in a region known as the Corn Belt. The second largest crop grown in the United States is soybeans.
How does Warren Buffett hedge against inflation? ›
Buffett on Inflation
Specifically, he said: “The best protection against inflation is your own personal earning power… No one can take your talent away from you,” Buffett said. “If you do something valuable and good for society, it doesn't matter what the U.S. dollar does.”
What is the #1 hedge against inflation? ›
Buy Treasury Bonds
There are two popular types of treasury bonds that are good investments for individuals who are worried about inflation: Series I Savings Bonds. Series I bonds are interest-bearing government savings bonds. They are a low-risk option that earn interest and are protected against inflation.
Where do you put money during inflation? ›
Top 6 Inflation Investments for the Future
- Equities. Equities generally offer a reliable haven during inflationary times. ...
- Real Estate. Real estate is another tried-and-true inflationary hedge. ...
- Commodities (Non-Gold) ...
- Treasury Inflation-Protected Securities (TIPS) ...
- Savings Bonds. ...
- Gold.
4 Best Tips For Successful Commodity Market Trading
- Treat Leverage With Caution. Unlike stock trading, commodity trading is characterised by high leverage. ...
- Understand The Market Cycle. ...
- Make Volatility Your Best Friend. ...
- Select The Best Broker.
Commodity trading can bring you profits if you are knowledgeable about the aspects that drive commodity prices. If you open a demat account today, and expect that commodity prices will give you returns tomorrow, you may be wrong. However, holding on to stocks for a long duration may bring you large gains in the future.
What is an example of a metal hedge? ›
A hedge involves establishing a position in the futures or options market that is equal and opposite to a position at risk in the physical market. For instance, a metals dealer who holds (is “long”) 50 ounces of platinum can hedge by selling (going “short”) one platinum futures contract.
Why should I trade commodities? ›
Diversification. Trading in commodities create a best portfolio diversification as the commodity prices move independent of other asset classes. In an economic turbulence, when the stocks, currency, and bond market falls, gold is considered as safe haven buying tool.
Why is commodity trading better? ›
The benefits of commodity market investments include lower volatility, hedging against inflation or geopolitical events, diversification, etc. And, the disadvantages of commodity market trading include high leverage, excessive volatility, higher dependence on macroeconomic factors, etc.
Why would you invest in commodities? ›
Advantages of commodity investing
Over time, commodities and commodity stocks tend to provide returns that differ from other stocks and bonds. A portfolio with assets that don't move in lockstep can help you better manage market volatility. However, diversification does not ensure a profit or guarantee against loss.
Do commodities go up with inflation? ›
Commodities are considered a hedge against inflation due to their intrinsic value and tend to perform well when prices for consumer goods are on the rise, while equities tend to perform poorly when high inflation leads to increases in interest rates, which tend to decrease the value of cash flows in the future for ...
Can we keep commodities for long term? ›
You will be surprised to know that you can actually invest in commodities as a long-term asset.
What is hedging in simple terms? ›
Hedging is an advanced risk management strategy that involves buying or selling an investment to potentially help reduce the risk of loss of an existing position.
What is hedging and its example? ›
Hedging is an insurance-like investment that protects you from risks of any potential losses of your finances. Hedging is similar to insurance as we take an insurance cover to protect ourselves from one or the other loss. For example, if we have an asset and we would like to protect it from floods.
Portfolio Hedging to Mitigate the Effects of Market Downturns. Investors can consider hedging strategies to mitigate market risk. A hedge, in its simplest form, is an investment intended to move in the opposite direction of an asset in your portfolio that you consider to be at risk. A hedge provides inverse exposure.
How do you hedge a stock portfolio? ›
Diversification is one of the most effective ways to hedge a portfolio over the long term. By holding uncorrelated assets as well as stocks in a portfolio, overall volatility is reduced. Alternative assets typically lose less value during a bear market, so a diversified portfolio will suffer lower average losses.
What is an example of hedging in the stock market? ›
For example, if Morty buys 100 shares of Stock PLC (STOCK) at $10 per share, he might hedge his investment by buying a put option with a strike price of $8 expiring in one year. This option gives Morty the right to sell 100 shares of STOCK for $8 anytime in the next year.
Why should I invest in commodities? ›
Investing in commodities can provide investors with diversification, a hedge against inflation, and excess positive returns. Investors may experience volatility when their investments track a single commodity or one sector of the economy. Supply, demand, and geopolitics all affect commodity prices.
What is the major disadvantage of hedging? ›
Following are the disadvantages of Hedging: Hedging involves a cost that tends to eat up the profit. Risk and reward are usually proportional to one other; thus, reducing risk will lead to reduced profits. For most short term traders, e.g., for a day trader, Hedging is a complex strategy to follow.
Is hedging always profitable? ›
Hedging in investing is used to manage risk by offsetting potential losses in one investment with gains in another. The goal of a hedge is not necessarily to make a profit, but rather to protect against potential losses.
What is a perfect hedge? ›
A perfect hedge is an investment vehicle designed to mitigate the financial risk inherent in a portfolio of investments and/or in the normal course of business.
Which strategy is best for commodity trading? ›
Top Commodity Trading Strategies in India
- Commodity trading is gradually emerging as a viable alternative to traditional investment options such as bank FDs, real estate, etc. ...
- Spread Trading. ...
- Options trading Strategies. ...
- Covered Short Put. ...
- Covered Short Call. ...
- Strangles and Straddles. ...
- Trading Strategies Using Commodity Indices.
Also, be sure to understand fundamental and technical analysis; discipline is also crucial.
- Be Willing to Learn Futures and Options. ...
- Know the Margin Requirements. ...
- Have Insights on Commodity Frequencies. ...
- Be Aware of Commodity Attributes. ...
- Know How to Use Trading Platforms. ...
- Understand Market Support and Resistance.
