Commodities 101: How does one invest in commodities?

This post is part of Asset Prime's "Commodities 101" series.

The most direct way to invest in commodities would be to actually buy or sell the tangible goods themselves. You know, like growing your own Soybeans and then selling them to a grain elevator, or renting space in a meat locker and filling it with Frozen Pork Bellies, or melting down old pop cans and casting the aluminum into ingots and then hoarding those ingots until Aluminum prices rise. If you're not quite up to that level of commitment, fortunately there are myriad financial instruments at your disposal to get you going. One of the easiest ways to invest in commodities, particularly for folks already familiar with equity trading, is to buy and sell the stock of corporations whose earnings rely heavily on commodities prices. Think gold prices are going up? Buy stock in Barrick Gold (ABX) or Harmony Gold Mining (HMY). Think Lumber prices are going down? Buy stock in home construction companies such as Toll Brothers (TOL), or maybe sell lumber producers like Plum Creek Timber (PCL) and Weyerhaeuser (WY) short. Got a hunch about Corn? Buy or sell Archer Daniel's Midland (ADM) and/or General Mills (GIS). The major drawback of this approach is that all corporations have factors other than commodities prices dictating their stock performance, so that the change in a commodity's price may not cause the desired effect in the stock price.

Another option would be buying or selling shares of mutual funds, index funds, or ETFs that seek to somehow track the prices of individual commodities or some basket thereof. These instruments, that typically trade like stocks on the major exchanges, are all relatively new to the investment world and each has its own unique means of "achieving" its price goals. Some buy the underlying physical commodities and keep them in storage, others hold futures contracts at a certain specified leverage, still others have more exotic ways of attempting to track the underlying commodities. While these instruments may be a good option for some investors, in general, there is a gap between the price movements of these funds and those of the underlying commodities, usually the result of the expenses of maintaining and managing the funds, or liquidity problems with the instruments.

All that said, other than buying and sitting on physical goods, the most direct and, for our money, best way to invest in commodities is via commodities futures contracts ("futures" for short). These instruments provide investors the most unmitigated access to the commodities markets possible. Because they're so important to the commodities markets, we'll go over futures contracts in greater detail in a later Commodities 101 post. For now, suffice it to say that "commodities" and "futures" are just short of being purely synonymous, and if you're serious about investing in commodities, you need to understand futures and how they work