Commodities are hard assets that is part of our everyday life. These are exchangeable in nature and physically movable from one place to another. Traders buy and sell commodities as papers in commodity market. The basic principles of supply and demand drive the markets similar to the equity market. Usually, only aggressive investors trade commodities due to higher volatility.
Commodities offer good option to diversify a portfolio as they provide natural hedge against inflation rates in an economy. For any investment to be fruitful, it is important that the returns generated beat the rate of inflation. In the case of commodities, higher inflation relates to the higher price of commodities. Therefore, commodity investments will result in a strong performance when inflation is high thereby providing a hedge against inflation.
The dynamics of supply and demand determine commodity price fluctuations. When there’s a big harvest of a certain crop, its price usually goes down. While drought conditions can make prices rise on fears that future supplies will be smaller than expected. Similarly, when the weather is cold, demand for natural gas for heating purposes often makes prices escalate, while a warm spell during the winter months can depress prices.
Commodities traded are typically are of four categories: metal, energy, livestock and meat, and agricultural. As their names suggest they are self-explanatory with one other type of commodity called Soft commodity, which means commodities that we drink like coffee, cocoa etc. They are sub classification of “Agricultural” type.
Drivers of commodity market.
Speculators: They are basically risk takers and never are associated with any particular commodity. They usually bet against the price moment in the hope of making gains.
Hedger: Hedgers are producers or consumers who want to transfer the price-risk on to the market. However, commodity market provides them an effective hedging mechanism against adverse price movement.
Commodities comes with a risk
Direct investment in the commodity markets is of high-risk, especially if you are a novice. Like they say, the greatest boon can sometimes be the biggest curse. Gains and losses are highly magnified. Commodity market tends to follow a trend and is highly volatile. There are government policies, transportation policies, weather reports and a lot more factors pertain to commodity. Sometimes it is very difficult to understand exactly what triggers commodities. Certain commodities with a high volatility also have a higher speculative risk, because the price will move significantly, which can result in large profits or losses.
Therefore before making investments, it is important to have a good understanding of the factors that influence the price of a commodity. This way an assessment can be made as to whether an investment is likely to make a profit or that it has a high chance to result in a loss. This will help decide how to operate on the market and minimize the speculative risk.