Commodities are those economic goods that are freely traded in the open market. Commodities are broadly categorized as hard and soft commodities in the financial markets.
What happens in the commodity market?
A commodity market involves buying, selling or trading these products. Usually, the price of the commodities is determined by various supply and demand factors. These prices can fluctuate, sometimes wildly, due to the macro-economic factors of a region or a country. Due to the massive volume of trade in these commodities and the fluctuation in prices, various financial instruments have become necessary to help farmers, producers, supply chain logistics, warehouses, and other businesses associated with these commodities in their trade.
These financial instruments help all these businesses to hedge their positions for better returns. Also, the financial markets, for commodities, being actively traded have attracted speculators and investors who trade, arbitrage and invest in this market.
The nature of trading differs with commodities as these assets are physical in form. Usually, the financial markets deal in currencies, interest rates, bonds and stocks. The underlying common factor to these types of instruments is finance.
What are hard commodities?
Commodities are split broadly into two categories for financial trading- soft and hard. Hard commodities are generally natural resources mined or extracted from the Earth. Examples of hard commodities are copper, gold, silver, crude oil, etc.
What are soft commodities?
On the other hand, soft commodities are grown, nurtured or raised. Agricultural products like soybeans, cocoa, coffee, cotton, sugar, rice, wheat and orange juice, and various livestock types are soft commodities.
Soft commodities are amongst the oldest traded products and continue to trade on various exchanges worldwide. These commodities are popularly called ‘softs’. They are also referred to as ‘tropical commodities’ or food and fibre commodities.
Soft commodities form a significant chunk of the futures market in this segment. Due to the vagaries of weather, various diseases, and other inherent risks that come with farming, the prices of these products tend to be highly volatile in a shorter time frame. Hard commodities are not unduly affected by these issues, and the supply and demand for these products are mainly predictable due to their static nature.
How can a financial instrument help?
These commodities come in predefined standard qualities. It is possible to quantify these assets numerically, creating a financial infrastructure to trade this asset class.
All the participants involved in the growth or mining of these commodities or the supply chain businesses, the storage house owners, the processors, and others use these financial instruments to safeguard their positions from the price volatility expected in the coming months.
Let’s consider an example of a farmer whose products may be expected to be ready in the next six months. Now, this farmer is unsure about the pricing he can get for his products in the future. A suitable way to solve this issue is to buy options. He can hedge his position by buying put options at a specified strike price, ensuring that the lot size is equivalent to his expected crop output. This strategy puts the farmer in a very convenient position as the minimum price of the product would be guaranteed to him, irrespective of whichever way the market may move.
Are the prices of these commodities volatile?
Both hard and soft commodities are traded in large numbers on various financial markets globally. Traders, speculators, and other market participants explore futures and options routes. An investor needs to be well aware of all the factors concerned with these commodities’ current and future pricing. Due to their nature of being very unpredictable and volatile, traders need to track weather patterns, consumption patterns, various government regulations and labour laws of different regions and countries to keep track of their investments or trades in this segment. Also to note is that volatility is more in soft commodities V/s hard commodities since soft commodities are perishable and have a shorter shelf life.
The impact of price fluctuations
For an investor, these commodities can act as an excellent tool in achieving diversification in his portfolio. As most of the other traded asset classes are related to finance and are inter-connected, in cyclical times, these instruments like bonds and shares may rise or fall in a sequence.
Investors can solve the above problem with the aid of commodities. Due to their everyday need and ready markets with huge traded volumes, the commodities can provide countermeasure during cyclical financial periods. It is often noted that when stocks and bonds fall, gold and other commodities rise in prices. Hence, commodities as an asset class can balance an investor’s portfolio with relative ease.
The current scenario
Nowadays, investing in commodities has become more accessible with the rise of mutual funds and ETFs that deal directly in this segment. Hence, trading and investing in commodities have risen in the last few years. In India also there are various exchanges facilitating trading in commodities. Of course, it is advisable to select the right broker for executing the trades. An investor should also be aware of brokerage and other charges involved in the trade.
Trading in commodities is catching up quickly with orthodox financial markets. Still, a trader needs to do his due diligence and be aware of all the risks and rewards associated with this asset class. Trading in commodities has also become popular due to the higher margins offered by brokers – studying the market patterns and supply-demand mismatch will reap good rewards for a trader.