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What is a commodity?

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Last editedJune 20212 min read

Whether you’re a seasoned trader or just thinking of trying out investing for the first time, the commodity market offers an intriguing alternative to the usual stocks and bonds. What is a commodity, and how does commodity trading in Australia work? We’ll explore these questions below.

Understanding commodities

A commodity is any physical good that’s interchangeable with the same type of good from other producers. For example, silver is the same product, no matter where it’s bought and sold. Commodities are broken down into several categories:

  • Hard commodities including raw extracted materials or natural resources like oil, natural gas, and gold.

  • Soft commodities include agricultural products like corn, wheat, and coffee.

The most popular commodity in Australia is crude oil, which can be traded over numerous international exchanges. Each commodity comes with its own unique code to assist with import and export worldwide, which you’ll need for declaring goods to cross-border customs agents. Yet commodity trading typically takes place over an exchange rather than in person, in which case each is ranked with a basis grade to assure it meets minimum standards.

The definition of commodity has recently expanded to include financial products like indexes along with technological units like cell phone minutes.

How does commodity trading work?

To help ensure the minimum quality standards of commodities, trading typically takes place on exchanges. Investors can take part in commodity trading either through futures contracts or forward contracts. The contract will come with a set price and volume, usually arranged months in advance.

For example, if the London Commodity Exchange is selling futures contracts for wheat, it might state that each contract contains 10,000 bushels for a prespecified price. It would also include relevant information about the minimum grade of wheat allowed for inclusion, regardless of which country it was grown in.

Commodity producers and buyers

For producers who are purchasing physical commodities, futures contracts help lock in a price ahead of time. Imagine that a large-scale bakery purchases the 10,000 bushels of wheat under the contract above. If the price of wheat rises before the prearranged delivery date, the lower price will still be locked in. At the same time, the wheat farmers can hedge against risk of their own with a futures contract to protect against the risk of wheat prices falling after the crop has already been planted.

Commodity speculators

Most commodity traders don’t trade physical products. The majority are speculators, who bank on the volatility of commodity prices. Prices go up and down quite a lot throughout the course of an average trading day, which makes speculation attractive to day traders. Index futures are also used to hedge against risk or for portfolio diversification. Rather than exchanging goods, traders simply buy and sell futures contracts with commodities as the underlying asset.

What impacts commodity prices?

Commodity prices fluctuate according to supply and demand, as with any asset. When the economy is in full swing, consumers will want to spend more on commodities like oil and agricultural products. If supply can’t meet the uptick in demand, commodity prices will increase as a result. On the other hand, sudden economic shocks can reduce demand for commodities which cause its price to plummet.

Another factor to consider when looking at commodity prices is the issue of inflation. Investors often look to the commodity market as a hedge for inflation, which causes prices to rise alongside inflation rates.

Commodity trading in Australia

Australia is rich in natural resources, including sizeable reserves of iron ore, coal, and natural gas. For these reasons, commodity trading in Australia is quite common. These products make up a sizeable percentage of the country’s exports. Trading in commodities led to an economic boom throughout the 2000s, when commodity prices rose steeply according to global demand. However, this trade decreased in the 2010s as demand for commodities fell.

It remains volatile today, so it’s worth doing your research before making any investment. Generally high-volume commodities are most stable, with gold and oil always popular choices.

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