Commodities are standard commercial goods that can be exchanged for other similar goods. Wheat, 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 trading commodities during market volatility because their prices often move against equities.
Guarantee Against Inflation
The cost of a commodity, which includes the raw resources used to produce something, increases with consumer demand.
An increase in interest rates and borrowing costs in an inflationary climate reduces the net profitability of the business. Any decrease in the company’s income will have an impact on the income distributed to shareholders.
Therefore, stock prices fall along with inflation. Conversely, when demand grows, the cost of raw materials used in production increases, pushing up the price of finished goods.
As a result, many who want to keep their money safe from inflation are turning to commodity futures.
Protect yourself from potentially catastrophic international events.
Conflict, riots, and war disrupt supply chains, making it difficult to get raw materials to producers who turn them into finished commodities, which in turn leads to scarcity of these resources.
When this happens, there is a mismatch between demand and availability of raw resources, which drives up commodity prices dramatically.
Stock prices tend to fall when widespread pessimism hits the market for reasons like this. Therefore, diversification into commodities is the best way to reduce portfolio risk.
Leveraged Investment Vehicle
Extreme leverage is available through commodity derivatives such as futures and options.
You can take over a sizable position with only 5-10% of the total contract value as initial margin.
Small changes in commodity prices can yield huge profits. Therefore, taking advantage of leverage in trading commodities opens the door to the prospect of massive profits.
Commodity futures often have lower minimum margin requirements than exchange trading. For wheat futures, the initial margin requirement is only 23% of the trade value.
Commodities and stock prices tend to move in opposite directions. Unfinished products often rely on commodities as a means of production.
Rising commodity prices push up production costs, cut profits, and allow shareholders to get a lower return on investment.
In the long run, this causes stock prices to fall.
Inflation also reduces the value of future cash flows generated by equity today because money in the future will buy more of the same amount of mini goods and services today. After this decline in value, the share price fell.
Thus, a steady or declining inflation rate benefits the stock market. However, when the inflation rate rises, commodity prices also tend to increase.
For example, when oil prices rise, so do vehicle maintenance costs, which in turn reduces demand for cars. That’s why car stocks also fell in value. The value of real estate stocks also falls as housing demand falls due to higher construction costs due to rising metal prices.
As a result of the inverse relationship between commodity prices and stock values, losses in stocks can be compensated for by gains in commodity derivatives. Therefore, investing in commodities broadens the scope of your portfolio.
Commodity exchanges are now conducted on electronic trading platforms open to all market participants, replacing the old protest approach.
Electronic trading platforms facilitate more transparent price discovery without direct interaction between buyers and sellers. There is no room for manipulation in the pricing mechanism as it is completely market based.
Price discovery occurs when the prices demanded by sellers and buyers are identical. Keeping the identities of both parties secret during the transaction eliminates the possibility of price manipulation.