Commodities are broadly defined as “generic, largely unprocessed, goods that can be processed and resold.” Investing in commodities represents an investment in the basic production inputs in the economy. By investing in commodities, an investor gains exposure to changes in commodity prices, which are ultimately driven by global supply and demand. A growing economy will see increased demand for commodities due to increased consumption, which puts upward pressure on prices. Higher prices typically result in increased supply coming online, which consequently drives prices lower. The key factors helping to drive demand over the long-term are a growing population, industrialization, and consumption while supply can be impacted by geopolitical events, weather patterns, or available capacity for processing commodities.
INVESTING IN COMMODITIES: AN OVERVIEW OF THE FUTURES MARKET
Investing in commodities is usually accomplished through the use of futures contracts and, therefore, understanding how the futures market functions is important.
Futures markets have been in existence for centuries and provide an efficient vehicle for buyers and sellers of goods to reduce price uncertainty and risk. A simple example would be a farmer who harvests a corn crop in the fall, but wants to guarantee a selling price several months prior to the harvest. The farmer can go to the futures market and sell a contract, whereby the purchaser of the contract agrees to buy his corn at a set price several months in the future. This transaction essentially eliminates the uncertainty that corn prices could drop prior to the time the farmer brings his crop to the market.
Alternatively, a company that buys large quantities of corn, may want to hedge its risk of rising corn prices by locking in a set price for some point in the future by buying a futures contract on corn. Although the purchaser of a futures contract agrees to take physical delivery of the goods upon expiration of the contract, most futures contracts are settled on a cash basis. In purchasing a futures contract, the investor posts a margin, that represents a percentage of the actual price of the futures contract and can be as little as 5% of the cost of the contract. As the price of the underlying commodity fluctuates and the value of the contract changes, the account is “marked to market” on a daily basis and the investor may be required to post additional funds to the account if the account value falls below a specified level.
INVESTING IN COMMODITIES: AN OVERVIEW OF THE FUTURES MARKET
Investing in commodities is usually accomplished through the use of futures contracts and, therefore, understanding how the futures market functions is important.
Futures markets have been in existence for centuries and provide an efficient vehicle for buyers and sellers of goods to reduce price uncertainty and risk. A simple example would be a farmer who harvests a corn crop in the fall, but wants to guarantee a selling price several months prior to the harvest. The farmer can go to the futures market and sell a contract, whereby the purchaser of the contract agrees to buy his corn at a set price several months in the future. This transaction essentially eliminates the uncertainty that corn prices could drop prior to the time the farmer brings his crop to the market.
Alternatively, a company that buys large quantities of corn, may want to hedge its risk of rising corn prices by locking in a set price for some point in the future by buying a futures contract on corn. Although the purchaser of a futures contract agrees to take physical delivery of the goods upon expiration of the contract, most futures contracts are settled on a cash basis. In purchasing a futures contract, the investor posts a margin, that represents a percentage of the actual price of the futures contract and can be as little as 5% of the cost of the contract. As the price of the underlying commodity fluctuates and the value of the contract changes, the account is “marked to market” on a daily basis and the investor may be required to post additional funds to the account if the account value falls below a specified level.
