Commodities - What are they and how do they work?This article is continuation to the series of educational articles on basic fundamentals in regards to particular asset classes.
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Commodities are basic goods used in commerce that are interchangeable with other goods of the same type. They are usually refined or used for production of other goods. Commodities can be traded privately or on public market exchange where they must meet specified minimum standards like quality, weight, type, etc. They are great speculative investments which tend to be ruled by cycles and interaction between supply and demand.
Classification of commodities
In order to distinguish between particular characteristics of each group, commodities can be categorized according to their type and origin. Commodities that are mined or extracted are called hard commodities (oil, gold, silver, etc.) while commodities that are grown are called soft commodities (wheat, rice, livestock, etc.). Though, commodities can be sorted even further into smaller sub-categories. For example, metals can be divided into industrial metals (copper, nickel, iron, etc.) and precious metals (silver, gold and platinum). Additionally, the agricultural sector can be divided into livestock and grains; and the energy sector can be divided into oil, coal and natural gas. Other commodity sectors can be subcategorized in the similar fashion.
Raw materials
Primary commodities which are unprocessed and serve as input for production of other goods are also called raw materials. Raw materials involve, for example, crude oil, copper, iron, wheat and corn.
Commodities exchanges include:
Asia Pacific Exchange (APEX) - Singapore
Chicago Board of Trade (CBOT) - United States
Chicago Mercantile Exchange (CME) - United States
Dalian Commodity Exchange (DCE) - China
London Metal Exchange (LME) - United Kingdom
National Commodity Exchange Limited (NCEL) - United States
New York Mercantile Exchange (NYMEX) - United States
Shanghai Gold Exchange (SGEX) - China
Correlation
Some commodities tend to show correlation with other assets. Such correlation can be positive or negative. Positive correlation means that two assets behave in a similar way. For example, when gold rises then mining stocks rise as well. Contrary to that, negative correlation describes such behavior in which assets move in the opposite direction to each other. For example, when USD/EUR rises then gold in USD tends to decline.
Illustration 1.01
Illustration above shows the monthly chart of USOIL. It also shows USDEUR (orange line). Negative correlation between these two assets is observable. When USDEUR falls then USOIL tends to rise.
Participants, spot market and derivatives market
Commodities are great anti-inflationary assets which are often sought by producers and speculators alike. Producers tend to use commodities with purpose to hedge their risk; furthermore, they often demand delivery of physical goods. Speculators, instead, try to exploit volatile price movements in commodities with the goal to profit from it. Commodities can be bought and sold through the spot market or derivatives market. Spot market simply means buying or selling cash positions while derivatives market involves investing in futures, options, ETFs, etc.
Seasonality
Some commodities are prone to seasonal cycles which means that they tend to show the same or very similar behavior based on a particular calendar season. For example, in some countries, production of a certain crop may vary during the wet season and drought season. Similarly, heating prices tend to increase during the harsh winter as opposed to during the hot summer. Concept of seasonality is also applicable to commercial and industrial trends.
DISCLAIMER: This content serves solely educational purposes.
