What are commodities?

Commodities refer to physical goods, usually raw materials used in manufacturing and production, that are essentially interchangeable. One bushel of wheat produced by an Iowa farmer is assumed to be equivalent to a bushel produced by a farmer in Russia. One ounce of gold just mined in Canada is no different than an ounce of gold melted down in Boca Raton.

Pay now, guarantee future price

Futures, or contracts to deliver a commodity at a future date at a certain price, are the chief security by which commodities are traded. For the seller or supplier of a commodity (usually a farming or mining business), and for the buyer or manufacturer (bread baker, jewelry maker, coffee roaster, microchip maker), buying and selling commodity futures is a way to reduce risk on all sides. If the price is agreed upon today, the parties can ignore the market fluctuations and focus on the business of production and manufacturing.

When you buy or sell a futures contract, the price is set today but payment is not made until the contract maturity (when the goods will be delivered). The buyer must put up a “margin” (which could be cash or Treasury bills).

Who invests in commodities?

Individuals and businesses who use commodities futures for investments fall into two groups, hedgers and speculators. Hedgers are one of the parties of the contract — either the producer or the consumer of the base commodity (the farmer or bread baker). They are seeking to hedge, or reduce, their risk of price fluctuations.  

Speculators are outside parties who seek to take advantage of these price fluctuations for short-term profit — and as such, are taking some of the biggest risks in the financial markets. A speculator who studied weather forecasts for the upcoming coffee-growing season, concluding that it would be more extreme than others expected, might buy a contract to purchase coffee beans — expecting the price to rise when bad weather destroyed some of the crops.

As you can see, the commodities market is more guesswork than financial acumen. While in limited cases extreme expertise or specialized information — seeing a bumper crop of cocoa beans still on the trees, perhaps — could make commodity trading less of a gamble, for most of us the term “speculation” is literal.

Don't “Get poor quickly”

Commodity futures are not the sort of investment most individuals would — or should — include as part of an investment portfolio, especially if that portfolio is intended as retirement savings. Commodities are extremely risky, even if you do know what you are doing. There are plenty of reasons that the main investors in commodities are called “speculators,” a term that has become synonymous with “risk-takers.” Our advice to most Get Rich Slowly readers would be “don't try this at home.” If you're insatiably curious, try it for fun on CommodityChallenge.com and let us know how you do!

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