Commodities are one of the available investment alternatives for investors. Investors can choose from among several tradable commodities:
- Metals (including precious metals) — gold, silver, copper, etc.
- Energy — oil, gas, and others
- Livestock and meat — feeder cattle, pork bellies, and others
- Agricultural — soy beans, corn, and others
- Soft commodities — coffee, cocoa, and others
Commodities are different assets than stocks and bonds. An important difference is that holding commodities does not pay the investor dividends or interest. Most stocks (company shares) usually give their holder regular earnings (dividends), and bonds usually give their holders a regular fixed interest payment.
Usually, market participants who buy or sell those commodities are doing so for one of many reasons:
- Speculation: they are looking to make a profit on price increase (in case of buying), or price decrease (in case of selling)
- Commercial purposes: a farmer may want to ensure that he can earn a certain minimum price for his crops to be harvested next year (by using a future contract)
- Hedging: investors may want to add one or more commodities to their portfolios to diversify assets in the portfolio and reduce risk
- Manufacturing or processing purposes: buyers may want to purchase a commodity that is an input in their manufacturing process.
From the above, it can be clear that there are many motivations behind participating in the commodities market. Several of those commodities are perceived to have a very important role in the global economy given their large size and significance, including gold, silver, and oil.
Is gold precious, a safe haven, or a currency?
Gold is famous for being the main exchange medium (or currency) before the rise of the US dollar — it has maintained high value throughout its long history. Some analysts even consider it the best holder of value. Due to its properties, people buy and hold gold for different reasons. In the past, gold used to be a currency but today it is more commonly a store of value.
Scarcity of gold has been one of the key reasons why it can maintain its status. Another is its acceptability. Furthermore, since the precious metal is dense, it can be easily stored.
And because gold has been known to hold its value well, many investors seek to buy gold when the conditions are turbulent in equities or bonds markets. For that reason, it is considered a safe heaven, especially as it shows less volatility with fluctuations in the business cycle. This is because gold is not heavily used in industry.
On the other hand, according to Ben Bernanke, the former chairman of the US federal reserve, gold can be mined just like any other commodity. It is a unique commodity but it behaves like a monetary asset.
In short, gold has properties of a commodity and a currency. In the financial markets, it trades like a currency, and it is priced in US dollar. Therefore, fluctuations in the value of US dollar may also have an effect on its value.
The size of the oil market used to be bigger than the size of all metal markets combined. Furthermore, the price of oil has severe implications on the global economy considering that it is the main source of revenue for many oil producing countries and it is a main expense for importing countries.
The Organization of Petroleum Exporting Countries (OPEC) is the most important player in the oil market. It sponsors agreements between governments of oil producing countries to maintain the oil price at reasonable levels.
The demand and supply of oil aren't really affected by the price on the short term given that production capacity mostly depends on mechanical rigs whose count changes little over the short term, and equipment that uses oil which is also fixed in the short term.
Commodities can be exchanged either directly between buyers and sellers (over the counter), or through an exchange.
Over the counter trading (OTC) occurs through a dealers' network, rather than a centralized exchange.
Furthermore, many brokers offer derivative contracts on commodities. Those contracts are called contracts for differences (CFDs). When you buy a CFD contract on a commodity, such as silver, for example, you are not actually owning the physical asset. Instead, you only gain money on the price increase (if you bought) or decrease (if you sold).
The CFDs use leverage. That is, you only deposit a margin of the money that you will actually trade with. For example, you deposit $1000 but the broker allows you to trade with $100,000. This is to increase your earnings potential, but it can also expose you to higher risk.
A famous CFD contract is the Gold CFD. Let's say you want to buy 2 ounces of gold, the price of each is around $1300. Instead of paying $2600 to buy the two ounces, you pay only $26 (1:100 leverage), and you own two ounces. If the price rises up to $1400 per ounce, you will have made $100 per ounce ($200 in total), whereas if the price drops to $1200 then you will lose $100 per ounce ($200 total loss). But if you had only put in $26 of capital, then your broker will stop you out of your position at $26 loss since you have no more capital to take risk.
Leverage is a two-edged sword. It can magnify your profits but also can expose you to higher risk — i.e. you can lose all your money very quickly due to small fluctuations in the market.
The foreign exchange market is a huge market with transactions that are said to exceed 5 trillion USD daily according to some estimates. This market is exceptionally liquid. In this market, currencies are offered in pairs, for example, the Euro against the US dollar (EUR/USD).
The first currency (Euro) in this pair (EUR/USD) is called the base currency, whereas the second currency (USD) is called the counter currency. The price of the pair expresses the exchange rate between the two currencies. For example, the EUR/USD today is at 1.2. This means that to buy €1 you need $1.2.
Many brokers offer traders leverage to trade forex to maximize their earnings.
Since currencies are offered in pairs, the logical pairs that have a common currency in them tend to have a degree of correlation in their movement. For example, the daily correlation between EUR/USD and AUD/USD is 87.9%. The reason this correlation is high is because the two pairs have USD as counter currency. Traders can check the correlation table offered here to make better trading decisions.
Traders may use those correlations to assess the risk of their portfolio. If a trader buys one currency and sells another highly correlated pair, then the two trades may cancel one another in terms of profit or loss.
Like many other instruments, currency pairs are offered in their spot prices, and there are derivative future contracts offered on them.
Spot prices refer to the instant market price of the asset, or the price "now".
The Spot forex market offers you to buy and sell currency pairs at the current market price (exchange rate). This is called the spot price, as opposed to the future price.
Future contracts are also offered on currency pairs, such as option contracts and forward contracts. Those contracts enable traders to buy or sell currency pairs in the future at a predetermined exchange rate.
Forex ETFs are exchange traded funds that hold a currency or a basket of currencies, or assets denominated in a foreign currency for the purpose of decreasing exposure to local currency. Forex ETFs use foreign currencies to diversify their investments and hedge against risk.
The property market is an attractive market with high returns if it is timed correctly. Different real estate markets in different locations have different performance depending on factors such as economic stability, income growth, unemployment, and location.
Investors can invest directly in real estate development companies by buying their shares at the relevant exchanges or by buying a property.
Another viable option is to invest in Real Estate Investment Funds (REIFs), or real estate funds. Those funds manage your portfolio of real estate investments for you, by buying assets in the real estate sector. The funds usually manage the diversification of the portfolio to keep risk at a minimum level.
Factors that real estate investors should take into account before making their decisions. Those can include:
- Location, which is the most important factor when investing in real estate
- Financial objectives and investment horizon
- Whether the investors want to invest in property under development or established property
- The purpose of investment
- Expected cash flow