What Is the Traded Instrument in a Commodity Market?

If you listen to daily market or economic reports, you often here commentators discussing commodities trading. The prices of pork bellies, wheat, oil and gold are used as economic indicators and as markets in their own right. As an investor, you can invest in commodities, but that doesn't mean you'll be taking delivery of a dozen sheep each week. There are three major financial instruments available to investors interested in the commodities market.

The most prevalent type of commodities trading instrument is the futures contract. These contracts are agreements between to parties to trade a particular item for a particular price at a particular point in the future -- the delivery date. For example, a corn producer might contract with a cereal company in May to sell 1,000 bushels of corn for $500 each to the cereal company in September. The contract provides certainty and insurance for both supplier and buyer -- prices may go up and down, but that price is locked in. Investors can buy and sell these futures contracts like options on stocks. A futures contract with a high price will be valuable when the price of the underlying contract goes down. An investor that owns this contract can sell it to a supplier or another investor before the delivery date for a profit.

If you prefer a less hands-on approach, you can purchase an Exchange-Traded Fund that invests in commodities. Like a mutual fund, ETFs pool investor money to invest broadly in a particular market, but the ETF shares are traded like stock shares. A fund manager selects which individual commodities to invest in, and takes care of the buying and selling. Shareholders reap the profits through dividends and rising share prices. Most funds invest in specific markets, trading the commodities themselves or the stocks of commodity-producing companies. There are some funds that invest in commodities futures as well, but these funds are considered very risky investments by most financial professionals. Many commodities index funds have very high initial investment requirements, which makes them impractical for many average investors.

Rather than going through a fund, you can buy stocks in commodity-producing companies, such as a poultry producer or oil refining company. These stocks are easily added to the investor's stock portfolio, and may be a good option for those looking to diversify their portfolios.

When trading commodities, it is vital to remember that all instruments are derived from real, physical stuff. Actual farmers raise wheat and beef, miners extract precious metals and energy producers pump oil out of the ground. There are many environmental factors that figure into commodity production and, therefore, into supply and demand. Crops are destroyed by hail, animals get diseases and pipelines break. These factors make commodities markets more volatile than other types of investments. Successful commodities investors are always aware of the complete economic picture as they trade.