What Are the Best Ways to Invest in Commodities?

Portfolio diversification remains the best way to minimize risk and grow your investments. As investors do this, they seek to add new assets and investment classes to their portfolios. Typically, they use stocks, bonds, real estate, and other well-known options to diversify.

However, commodities do not always come up in conversations about diversification, meaning many investors do not even consider or know about them. Savvy investors have been using them to smoothen out returns and leverage various opportunities as they come up. In this article, we will look at what they are, why you should invest in them, and the best ways to invest in commodities.

What are Commodities?

Commodities are raw materials and products used directly or to create other products. For example, oil is a commodity used to manufacture plastics, and numerous other products. Beef or corn, on the other hand, are commodities that we consume as-is, even though we also use them to manufacture other goods.

What Are the Benefits of Investing in Commodities?

Arguably, the most significant advantage of commodities as an investment class is that they are an excellent hedge against inflation. Their prices tend to rise with inflation, which is why they are also used as indicators of rising inflation. This happens because inflation causes other investments to perform poorly, causing people to switch to commodities. Once they do, their demand increases, and their prices and value do the same.

They also provide the potential for significant returns. Gold, oil, and commodities with cyclical production experience price fluctuations. The reason is that they are sensitive to various external factors, including news, geopolitical realignments, production shortfall, and events that affect regional or global supply chains.

They also provide excellent diversification opportunities. They do this because they have a low or soft correlation to other financial assets.

Lastly, you can hold them as physical assets. Gold is a great example of this because we have used it as a store of value for a very long time. If there is a base demand for a physical commodity that acts as a store of value, there is always the potential that its price will increase, leading to profits.

How to Invest in Commodities

There are numerous commodity investment options depending on your preferences and the type of trader you are. Some are complex, while others are more straightforward.

Physical Ownership

Physical ownership works best for small commodities that are easy to transport and store, such as precious metals. It is a basic option, is easy to understand, and you can get started with a small amount if you can find a reputable dealer or seller.

While you can buy commodities like wheat or soybeans to store and sell later, that is not always a practical option. Also, their price can change so much that you may not be able to sell the commodity and recoup its cost and that of storing it.

Commodity Options

An option contract gives the holder the right to buy or sell an underlying asset at a set strike price on or before a specified expiration date. The holder pays a premium for this right. Options can be purchased on various securities and commodities, like a commodity option which gives the holder the right to buy or sell a commodity like oil or gold at the strike price before expiration. Options are useful investment tools for speculation or hedging risks.

When trading options, you can either buy a call or put option. A call option allows a trader to buy the underlying commodity at the agreed-upon date without the obligation to do so. The call option buyer will only execute the contract if the strike price is lower than the prevailing commodity price. In doing so, they will have bought the underlying commodity at a lower price than the prevailing market rate, making a profit from the difference.

A put option is the opposite. The trader has the right to sell the underlying commodity but doesn’t have an obligation to do so. They profit from that trade if the commodity’s price falls below the strike price. The reason is that they will sell the contract at a much higher price than the current market rate, making the difference in profit.

It is crucial to understand that the seller or buyer doesn’t have to execute the contract. If they do not, they lose the premium (the amount paid to open the contract.) Option selling can be highly profitable, but it comes with some risks, especially for the seller. You can avoid these mistakes and ensure they become a significant part of your investment strategy by learning all you can about option selling, managing risk better, and avoiding common mistakes.

Commodity Futures

Futures contracts are meant to help farmers lock in a price so they can sell at that level in the future. The main difference between futures and options is that traders are obligated to execute the former at the expiry date.

This provision increases risk, especially when you consider that the price might fall so low that you cannot sell the contracts you hold unless you are willing to incur the loss. However, they are highly profitable, especially when disease, weather, and other factors affect corn, soybeans, and wheat conditions, reducing their supply and leading to price increases.

Mutual and Exchange-traded Funds

You can also invest in funds tied to specific commodities like gold and other precious metals. Investors like this option because it gives them a much wider exposure to the commodities market. This spreads out their risk while allowing them to profit from positive price movements.

If you are interested in either, you should know that they typically invest in commodity futures or options, and you do not end up holding any physical commodity. As with funds that track different underlying assets, a downturn in one of the sectors or commodity classes included in the fund will cause its value to change drastically. So, do your research and find balanced options that will not be affected too much if this happens.

Commodities are an excellent investment option but are severely underrated. Many investors choose other asset classes because they are not aware commodities can be highly profitable and a great diversification option. They also have several benefits, and you have several ways of investing in them depending on your interests and goals.