Commodity Investing: How the Commodity Markets Work

Commodity Markets

In building up a balanced portfolio of investments one strategy is to expand beyond a basic portfolio of stocks and shares and to consider an investment in more exotic securities. One such security is to consider an investment in the commodity markets.

What are the Commodities Markets?

The commodities markets are used by both industrialists wishing to buy large amounts of a given commodity to take psychical delivery of, as well as private and institutional investors who simply wish to gain an exposure to fluctuations in the underlying price a commodity.

A wide range of commodities are available for investment, with exchanges specialising in related product areas. For example, Chicago is famous for its exchange specialising in food commodities such as grain and pork bellies. London on the other hand, has several well known exchanges famed for transactions in both precious and base metals. Other popular commodities include oil, gas and other forms of fuel.

In essence, the commodities markets work on the same basis as those of the stock exchange. A commodities exchange sees buyers and sellers coming together to exchange contracts for the sale of various commodities. Prices, like on those of the stock exchange are determined by the laws of supply and demand as traders react to the volume of trade and events within the external environment.

Investing in Commodities: Derivatives – Futures and Options

If considering investing in the commodities markets, then basic derivatives such as futures and options are two common options. In the case of industrial investors, commodities may be physically received however, it is more common for such derivatives to be settled in cash for private and institutional investors.

Futures – Here an investor agrees to buy a commodity at a certain price in the future, this price is known as the strike price. When the settlement day arrives, the investor must then pay the price of the contract at the strike price.

If the price of the commodity has risen, then a profit will be made as the investor is able to buy the commodity at a discount in comparison to the market rate. If however, the commodity has fallen in price, then a loss will be incurred as the investor has to pay premium in comparison to the market rate.

Options – Here the investor buys the option to buy a commodity at a certain price in the future however, this is not an obligation to buy. For the privilege of the option an investor will pay what is referred to as a premium to the writer of the option. Should the price of the commodity rise, then the investor will exercise their option to buy the commodity.

A profit will be made by purchasing the comity at a discount in comparison to the market rate. If a commodity has fallen in value, then an investor will simply fail to exercise the option and thus the loss is limited to that of the premium paid.

In summary, the commodities markets represent one way of diversifying a portfolio of investments. However, in order to make a profit it is recommended that a variety of tools are researched first, including physical investment, futures and options.