A commodity index is a weighted average of the prices for various commodities in a particular category. It is designed to track the overall price movements of that type of commodity. There are also indices which cover all commodities rather than being limited to one particular type. Some investors choose to invest in financial instruments which are tied to the index.
In principle, a commodity is any physical good which can be bought or sold. The most common forms of commodities include metals and agricultural goods such as livestock or grains. A commodity index can also cover some forms of energy such as electricity or gas, but it can't include financial products such as stocks or currencies.
In most cases, a commodity index will cover an entire category such as precious metals. Within this index, there may be more than one form of each individual commodity. For example, an energy index may include multiple types of petroleum such as crude oil, heating oil and gasoline. There are also some indices which cover all commodities.
It’s important to note that in some cases, the commodity prices do not relate to how much you would have to pay for the commodity today. Instead, the prices are often for futures trading in which the buyer is paying for either the right or the option to buy the commodity at a particular price on a set day in the future. This is very common in agricultural commodities such as livestock or grain where the goods won’t be ready for use until some time in the future. As people buy and sell the rights to purchase these goods when they become available, they are effectively gambling on what the demand and supply will be at that point.
The commodity index will usually be weighted. This means it isn’t simply an average of the various commodities it covers. Instead the formula used for calculating the index will be biased to give emphasis or “weight” to particular commodities. Usually the index will give extra weight to the commodities which are traded in the largest quantities. The idea of weighting is that the index should better reflect the overall movements in the particular market sector.
While a commodity index serves as a useful guide to whether or not it is worth investing in commodities as a whole, it has other uses. Investors can buy or sell financial instruments which are based on the performance of the index. To give a very simplified example, a firm may sell a contract promising to pay out on an energy index on December 31 one US Dollar (USD) per point.
That means that if the index in question is at 4310 on that date, the firm would pay out $4,310 USD to the contract holder. Investors can then buy and sell the contract throughout the year, with the goal being to buy the contract for less than the eventual payout. As a general rule, if the index rises during the year, the price people are willing to pay for the contract will also go up because the chances are better that the eventual payout will be even higher. Somebody selling the contract before it comes due may either believe the index has peaked and will decline, or have decided to take a small profit now and avoid taking any further risk.