A commodity is a standard commercial good that may be exchanged for others of the same kind. Grain, gold, meat, oil, and natural gas are classic examples of commodities.
Commodities offer an opportunity for investors to diversify their holdings beyond just stocks and bonds. Some investors turn to commodities trading during market volatility since their prices often move opposite to equities.
Assuring Against Inflation
The cost of commodities, which include the raw resources used to produce things, rises in tandem with consumer demand.
Increased interest rates and borrowing costs in an inflationary climate lower a business’s net profitability. Any company revenue decrease will knock on the earnings distributed to stockholders.
Therefore, stock prices decrease with inflation. Conversely, when demand grows, the cost of raw materials used in production increases, pushing the price of completed items.
As a result, many who want to keep their money safe from inflation turn to commodities futures.
Protect yourself from potentially catastrophic international events.
Conflicts, riots, and wars interrupt the supply chain, making it harder to get raw materials to the manufacturers that turn them into completed commodities, which in turn causes a shortage of those resources.
When this happens, there is a mismatch between the demand for and availability of raw resources, which drives up commodity prices dramatically.
Stock prices tend to plummet when widespread pessimism hits the market for reasons like these. Therefore, diversifying into commodities is an excellent way to mitigate portfolio risk.
Leveraged Investment Vehicle
Extreme leverage is available through commodity derivatives such as futures and options.
You can take command of a sizable position with only 5–10% of the total contract value as the initial margin.
A small change in commodity prices can result in enormous profits. Therefore, utilising leverage in commodities trading opens the door to the prospect of massive profits.
Commodity futures often have lower minimum margin requirements than stock exchange trading. For wheat futures, the initial margin requirement is just 23% of the trading value.
Diversification
Commodities and stock prices tend to move in opposite directions. Products that are not yet finished often rely on commodities as a means of production.
Rising commodity prices drive manufacturing costs, cutting profits and leaving shareholders with less of a return on their investment.
In the long run, this causes stock prices to fall.
Inflation also reduces the current value of future cash flows delivered by equities since money in the future will purchase more miniature goods and services for the same amount today. Following this decline in value, stock prices fall.
So, a steady or decreasing inflation rate benefits the stock market. When inflation rates rise, however, commodity prices also tend to increase.
E.g., When oil prices rise, so does the expense of maintaining a vehicle, which in turn dampens demand for automobiles. That’s why car stocks are going down in value too. Real estate stock values also decline when demand for housing drops because of higher construction costs due to rising metal prices.
As a result of the inverse relationship between the price of commodities and the value of stocks, losses in stocks might be offset by profits in commodity derivatives. Therefore, investing in commodities broadens the scope of your portfolio.
Transparency
Commodity exchanges are now performed on an electronic trading platform open to all market participants, replacing the older outcry approach.
The electronic trading platform facilitates more transparent price discovery without direct interaction between buyers and sellers. There is no room for manipulation in the pricing mechanism because it is entirely market-based.
Price discovery occurs when the seller’s and buyer’s asking prices are identical. Keeping the identities of both parties hidden during the transaction eliminates any possibility of manipulating prices.
