Commodities

Why this matters

This lesson is optional. Oil, gold, and wheat prices are in the news constantly, and commodity funds sit next to stock funds in every brokerage app. They work very differently from stocks and bonds, though, and some of the most popular ways to invest in them don't do what most buyers expect.

What commodities are

Commodities are the basic goods that everyday life is built on. They include metals such as copper, gold, and silver; energy such as crude oil and natural gas; crops such as wheat and coffee; and livestock such as cattle.¹ One barrel of a given grade of oil is as good as any other, which is what lets them trade in large, standardized amounts.

The big difference from everything in this part so far is income. A share is a claim on a company's profits, and a bond pays interest. A barrel of oil or a bar of gold pays nothing. Your return comes only from the price changing, and commodity prices are driven by supply and demand: harvests and weather, mine output, wars and trade disputes, and how fast the world economy is growing. Why Prices Move covers how supply and demand set prices.

Four ways to invest

FINRA describes the main routes: owning the commodity directly, trading futures, buying funds and exchange-traded products, and owning shares of companies in commodity businesses such as mining or refining.¹

1. Owning it physically. For most people this means gold or silver coins and bars. You pay a dealer's markup, and you need somewhere safe to store it. The CFTC warns about metals dealers who use cold calls, infomercials, and limited-time offers, and suggests asking what the dealer would pay you if you sold the metal back tomorrow. Some fraudulent dealers have charged spreads of more than 300%.²
2. Futures contracts. A futures contract is an agreement to buy or sell a particular commodity at a future date, with the price and amount fixed when the agreement is made. Most participants are hedgers, such as producers and buyers of the commodity managing their price risk. Others are speculators trying to profit from price changes. Most contracts are closed out before the delivery date.³ A small deposit, called margin, controls a contract worth far more, which magnifies gains and losses.¹ The CFTC warns that many individuals lose all of their money and can be required to pay more than they put in.³ The CFTC regulates futures markets.¹
3. Funds and exchange-traded products. Some, especially gold and other precious metals funds, hold the physical metal in vaults. Many others hold futures contracts instead. Futures-based products are often set up as commodity pools or exchange-traded notes. These aren't investment companies like ordinary mutual funds and ETFs, so they may offer less investor protection.¹
4. Shares of commodity companies. Miners, oil producers, and refiners. Their profits rise and fall with commodity prices, but you're still buying a business, with its own costs, debts, and management.