With all the current volatility in the world’s stock markets, a lot of people are wondering whether it makes sense to invest in anything at all at the moment.

Well, I personally see drastic stock market drops as a chance to buy stocks on sale before the price eventually goes back up. But beyond that, there are alternatives to stocks for those who can’t stomach the current state of affairs.

An alternative to stocks is investing in commodities. What are commodities? They are raw materials used to create products that people really need. Things like food, agricultural products like wheat and cattle, oil and gas, and metals like gold, silver, and aluminum.

How are commodities bought and sold?

Most commodities used to be just sold at the local market. Obviously that would present some trouble for the individual investor who can’t store cattle or wheat at home. But in the 1800s, commodity future exchanges were set up.

Future and option contracts on commodities can be traded on exchanges around the world. So you no longer have to possess the actual barrel of oil itself, you can possess a contract to own it in the future, and these contracts can be sold.

Futures and options are advanced trading avenues and in my opinion are best avoided for the novice investor. But these days there are other ways to invest in commodities, like buying units in a mutual fund that buys commodity futures.

Why invest in commodities? What are the benefits?

In recent years commodities prices have outperformed stocks and bonds. One reason is that demand for commodities from developing countries is increasing. As massive developing countries like China and India build infrastructure and increase manufacturing, steel, oil, and other commodities will be needed in huge quantities.

Increased demand, coupled with decreased supply for some commodities such as oil, will continue to send prices higher. With Asia’s rapid development this will likely continue.

Commodities also move up when stocks go down. Commodities are real assets, unlike stocks and bonds, and they react differently to changing economic conditions. Commodities prices tend to increase with inflation. Stocks and bonds on the other hand, tend to perform better when the rate of inflation is stable or slowing.

Since 1990, commodity prices have been negatively correlated with the S&P 500. Since commodities are not positively correlated with stocks and bonds, they diversify your portfolio and help reduce risk and increase returns over time.

Commodities are not only a hedge against inflation, but also a hedge against destabilizing events or catastrophes. Commodity prices rise during times of crisis such as wars and stock market crashes. After the Iraqi invasion of Kuwait, stocks dropped while commodities performed well. And during the stock market crash of 1987, stocks dropped by 30% while commodities held steady.

There are people out there who horde gold as a way to preserve wealth in some coming cataclysmic event. I would never want to invest in ONLY GOLD, but these people are right that in the event of catastrophe commodities like gold will be far more useful than stocks or cash (which will likely become unbelievably devalued if there’s a catastrophe of huge proportions).

That’s not to say that commodities are free of volatility. They are equally or slightly more volatile than the stock market, but they rarely drop at the same time as the stock market. In these volatile times with stocks continuing to drop or stagnate, commodities are an essential part of any diversified portfolio.

Remember that freshman Human Anatomy class you had to take in college? The professor pulled out “Mr. Bones” or whatever name the class skeleton had and the following drill was the same. The professor would proceed to quiz the class while teaching the underlying structure of the human body. The same exercise is valuable in commodities trading as well; looking at the “skeleton” of a commodities options contract is helpful for understanding its body.

Dissecting the Body of an Options Trading Contract

While these features do not represent all of the aspects of an options trading contract, they do create its structure:

• Underlying Asset – In order to write an options trading contract, you certainly have to include the commodities that contract is buying. Corn futures, gold and silver are all examples of commodities that can be underlying assets.

• Strike Price – The strike price, which is also known as the exercise price, is amount for which the commodities will be sold or bought if the commodity trading occurs as detailed in the contract. It is the difference between the current price and the strike price that gives either the buyer or seller their profit.

• Exercise Style – The exercise style is important to the successful trader because of the impact it has on investment strategy. An American style contract means that the contract can be exercised at any time up to the expiration date. European style contracts can only be exercised on the expiration date. This information is included in the contract.

• Expiration Date – For European contracts, this date is when the contract will be executed. For American contracts, this is the last day for futures trading on this contract.

Factors Affecting Commodities Contracts

There are a number of factors that can have an effect on commodities contracts. These factors can determine when a contract is implemented, when it is exercised and how much it costs. Futures contracts have variables such as:

1. Current Price Relative to the Strike Price. Depending on the investment philosophy involved, a trader might buy commodities that are “in the money”, “out of the money’, or “at the money.” These terms are comparative between the strike price and the current price.

a. In The Money – If a commodities contract is already profitable when it is purchased, it is referred to as in the money. Sellers will sometimes use this investment strategy when they believe that a commodity price will fall, taking it out of the money.

b. Out Of The Money – If a commodities contract is purchased while it is still losing money; it is referred to as out of the money. If a call option is purchased when the current price is below the strike price, it would fall into this category.

c. At The Money – If the current price and the strike price are the same, the contract is at the money.

2. Premium Price. The premium is the amount that the investor will pay to purchase a particular futures commodity. This amount is affected by several factors but it is basically the cost of a commodities contract.

3. Length of a Contract. The time from the purchase date of a contract until its expiration date can affect the cost of the premium. The longer the contract, the more likely that the terms of the contract will be met; this means that the premium would go up to reflect that probability.

4. Complexity of the Contract. The type of contract written on futures options can affect the premium price. A simple market order that is out of the money will cost less than selling covered calls.

Conclusion

Commodities can be complex and their contracts can contain many things. Looking closely and examining the “skeleton” of a commodities contract and understanding its investment basics can help “pass the test” of being a successful investor. And you don’t have to worry because we won’t even need Mr. Bones!