Commodity trading relates to the buying and selling of a large range of instruments including oil and gas, metals and cocoa, coffee, wheat and sugar. Commodities are categorised as hard and soft commodities. Hard commodities are metals or energies such as gold and gas, and soft commodities are agricultural products like cocoa, wheat and sugar.
Commodity trading is appealing due to the higher risk/return ratio. Commodity trades are highly leveraged which means that the margin required for trading is quite low compared to the overall position.
Read on to learn all about investing in commodities.
A History of Commodities Trading
Trading commodities has a longer history than the trading of stocks and bonds. In the present-day, commodities are still exchanged throughout the world. A commodities exchange refers both to a physical location where the trading of commodities takes place and to legal entities that have been set up in order to enforce the rules for the trading of standardised commodity contracts and related investment products.
Commodity types
- Metals. Metals include gold, silver, platinum, and copper. During periods of market volatility, some investors may invest in precious metals, especially gold, because of its status as a reliable metal with real, transferable value. Investors may also invest in precious metals as a hedge against periods of high inflation or currency devaluation.
- Energy commodities. Energy commodities include crude oil, heating oil, natural gas, and gasoline. Global economic developments and reduced oil outputs around the world have historically led to increasing oil prices. This is due to higher demand for energy-related products while at the same time oil supplies have declined.
- Agricultural commodities. Agricultural commodities include corn, soybeans, wheat, rice, cocoa, coffee, cotton, and sugar. In the agricultural sector, grains can be very volatile during the summer months or during periods of weather-related transitions. Population growth combined with limited agricultural supply can provide opportunities for investors when prices of agricultural commodities increase.
- Commodities exchanges. Commodities are traded on exchanges that specialise in particular markets. In recent years, some commodities exchanges have merged or gone out of business. In the US, there is the Chicago Mercantile Exchange (CME), the New York Mercantile Exchange (NYMEX), and the Intercontinental Exchange (ICE) in Atlanta, Georgia. In Europe, there is the London Metal Exchange (LME).
Supply and demand
Supply and demand drive the commodities markets. Changes in supply affect the demand. Low supply means higher prices. So, if there are major changes in the supply of a commodity, this can lead to higher prices.
Benefits of trading commodities
- Diversification. Commodities trading is a good way to diversify your portfolio and hedge against risks as the prices of commodities may move in the opposite direction to other assets such as stocks.
- Hedge against inflation. The prices of commodities usually rise when inflation is increasing, so commodities can provide a hedge from the effects of inflation.
- Ability to go long or short. You can trade rising and falling markets with commodity CFDs and speculate on the price of a commodity going up (go long) or down (go short) without owing the underlying asset.
- Trade with flexible leverage. CFDs are leveraged products. This means you can use a small position to gain greater market exposure to the financial asset.
How to trade commodities
Commodity trading for beginners involves speculating on the value of a given commodity and gaining returns from volatility in the commodity markets. There are different ways to trade commodities and include the following:
- Commodity stocks. You can gain indirect exposure to the commodity market by buying and selling the shares of companies that are involved in the mining, extraction, growth or harvesting of any type of commodity. Some commodity prices move in opposition to stocks, which makes commodities a popular way for investors and traders to hedge their portfolios. Other commodity prices move in parallel with their corresponding stocks.
- CFDs (Contract for Difference). With CFDs, you can speculate on the price movements of an underlying asset without owning or taking physical delivery of the underlying commodity.
- Commodities Futures. Another way of investing in commodities is through a futures contract. This involves entering into an agreement to buy or sell the commodity at an agreed price on a future date. This agreement is also speculative and you do not own or take physical delivery of the underlying asset.
- Exchange-Traded Funds (ETFs) and Notes. Exchange-traded funds and exchange-traded notes are additional options for investors who want to enter the commodities market. ETFs and ETNs trade like stocks and there is the opportunity to make a profit from fluctuations in commodity prices without investing directly in futures contracts.
- Commodity Stocks. Traders can buy the stock of a company that produces the commodity. These stock investments follow the price of an underlying commodity. Therefore, if the price of the commodity goes up the company will be more profitable as its share price will increase too.
Final thoughts
Both beginners and experienced traders have several different options for investing in financial instruments and gaining access to the commodity markets. Commodity futures contracts provide the most direct way to participate in the price movements of the industry, but there are other types of investments with less risk that also provide enough opportunities for commodities exposure.
However, commodities can be risky investments because they can be affected by uncertainties that are difficult to predict, such as unusual weather patterns, epidemics, and both natural and human-made disasters.
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