Commodity investing involves investing in raw materials that can be categorised into hard commodities that are extracted, such as oil and gas, or soft commodities that are grown, such as crops and livestock. There are several different ways to invest in commodities.
Investing in the actual asset
The most direct method of commodity investing would be to purchase the actual commodity itself. Obviously this method only works with certain commodities, such as the precious metals, but nonetheless it is still a way to gain exposure in these markets.
If you wanted to invest in gold, for instance, you could purchase a gold bullion. This is a quantity of refined gold that adheres to standard conditions of manufacturing, labelling and record keeping.
However, there are many issues with this form of investment. You have the immediate issue of having to store the asset. This type of investment is also relatively less liquid than others, so it is subsequently more costly to exchange.
Investing in an exchange-traded fund
Alternatively, many people who invest in commodities do so by investing in commodity-based exchange-traded funds (ETFs). An ETF is a fund that is traded on a stock exchange. It can be comprised of many different asset classes from stocks, commodities or bonds. Some ETFs will aim to track the price of the underlying commodity itself, like physical gold ETFs. Alternatively, some will attempt to track a commodity through comprising an ETF. That may hold stocks in companies that extract or mine that commodity. The latter type of ETF can be known to have a more divergent price from that of the underlying commodity.
Investing in a futures contract
Commodities futures are agreements to buy or sell a given amount of a raw material at a particular price and specified date in the future. A trader gains money if the commodity appreciates or depreciates relative to the fixed price.
Futures are a derivative product, so you do not own the underlying commodity itself. Buyers may use futures to hedge against risks associated with price fluctuations and sellers can use futures to ‘lock in’ gains on their products.
Investing in CFDs on commodities
Investors can trade CFDs on commodities as a means of gaining exposure in the commodity markets. A contract for difference (CFD) is a derivative product. There is an agreement (usually between a broker and an investor) to pay the difference in the price of an underlying asset between the start and finish of that contract. You trade CFDs on margin, meaning that you only have to put up a fraction of the value of your trade. Leveraged trading allows traders to gain more exposure with a smaller initial deposit.
Investing in commodities by trading CFDs brings many advantages. CFDs are exempt from stamp duty, owing to it being a derivative product, so you would have fewer costs trading CFDs.