Nov 12, 2020
Commodity trading is as old as civilizations. Basic goods and raw materials used to create complex goods are called commodities, and they have been traded for thousands of years. However, a modern-day commodity market is very different from the physical one that existed back then. Today, traders use digital trading platforms such as the London Metal Exchange (LME).
So, what exactly are commodities?
Commodities are categorized as hard and soft commodities. Hard commodities are mainly natural resources like gold, crude oil, and copper. Soft commodities are products that are grown, such as cotton, livestock, and sugar.
Commodities are synonymous with resources, and humans rely on a variety of resources every single day. We need petrol to drive, livestock or agricultural produce to eat, copper to build with, gas to keep us warm and so on.
Commodities are interchangeable, meaning that they are of the same quality as other goods of the same type. A barrel of crude oil in America is identical to a barrel of crude oil in Saudi Arabia or Russia.
Are commodities all the same?
Absolutely not. Commodities are further separated into four categories.
1. Metal Commodities
These include gold (XAU), silver, copper, aluminium, platinum, etc. We rely on metal commodities for developing and building, for making jewellery, minting coins, and many more.
2. Livestock and Dairy Commodities
These include live cattle, pork bellies, lean hogs, and so on. A modern-day diet includes a significant amount of meat, as well as cheese, eggs, and milk. Humans, households, restaurants, farmers, grocery shops, and bakeries all rely on these products.
3. Energy Commodities
These include crude oil, helium, uranium, gasoline, ethanol, and more. They are vital goods in a variety of sectors. For instance, households rely on gas for heating, uranium is used for fuel in nuclear power plants, and gasoline is used for vehicles.
4. Agricultural Commodities
These include oats, rice, soybean, wheat, fruits, vegetables, and many more. Our primary necessity for these is for consumption; however, some do have multiple uses. For instance, corn is also used as an ingredient in fuel production.
Why are commodities traded?
Commodities are mainly traded for profit. Because the commodities market is largely affected by supply and demand, the prices of commodities can be quite volatile. The commodity market has two principal agents: the hedgers and the speculators.
The speculators are constantly analyzing the market and trying to forecast the price movement. If they predict that the value of a commodity will increase, they buy that commodity, and once the price increases, they sell it at a higher price pocketing the difference.
The hedgers are usually retailers or manufacturers – those who receive the physical goods. They are greatly affected by the prices, exchange rates, and interest rates; therefore, their purpose for trading commodities has more to do with offsetting losses rather than making profits.
For example, let’s say investor A agrees with Investor B, which stipulates that in 2 years, Investor B will sell 50 kgs of sugar to Investor B for the price of $1 per kilo, thus in total $50. The price they settle on represents the current market and their individual predictions. In 2 years’ time, if the price of sugar has dropped to $0.8 per kilo, Investor B will have made a profit however, if the price has increased to $1.2 per kilo, then Investor A has profited.
What are the benefits of trading commodities?
Registering with your broker to begin trading commodities gives you the following:
- A market that is practically always open and allows you to trade whenever you want
- Many opportunities to make a profit
- Protection against inflation as commodity prices rise along with the demand
- The option to use leverage – a tool that allows you to control a large amount of money with just a small initial deposit by using borrowed capital.
- Diversification of your portfolio, which leads to lower risk
How are commodities traded?
As we’ve already mentioned, a modern commodity market is a virtual place where both hard and soft commodities are being bought, sold, or traded. Commodity markets consist of physical trading and trading financial derivates.
Physical trading is precisely what it sounds like; retailers, manufacturers, and others are buying, selling, and trading the actual physical commodity. On the other hand, financial derivatives are financial instruments that derive their value from the underlying asset but not the asset itself.
There are many different ways that you can invest and profit from the commodity market. For instance, you can purchase stock in a company that deals in commodities or invest in the mutual index or exchange-traded funds, which are commodity-related. However, buying futures and contracts-for-difference (CFDs) are generally the most candid ways to get involved in the commodities market.
What affects commodity prices?
The commodities market is almost exclusively driven by supply and demand. Global occurrences such as development, technology, political and economic circumstances, consumer trends, interest rates, government policies, and weather affect the prices.
Supply is affected by the weather, government policies, and geopolitical events. In contrast, demand is primarily influenced by growth in the emerging markets, technological advances, consumer trends, and the economy’s state.
Are there any strategies that can help with commodity trading?
When speculating a particular asset, every investor’s main motive is to trade it at the most profitable time possible. This is why commodity traders tend to use both fundamental and technical analysis to make better, more lucrative trading decisions.
Technical analysis is used to check the previous prices and trends of the stock in an attempt to predict future price fluctuation of that asset. It is supported by technical indicators and statistics.
On the other hand, fundamental analysis is a deep dive into all company-related information such as the market value of the share, the economy’s state, the company’s growth, earnings, and many others. It is supported by macroeconomic, company-specific data, and financial ratios.
What are the risks associated with commodity trading?
All trading involves a certain degree of risk; however, not all trading carries an equal degree of risk. Trading in the commodity market carries with it two potential risks; leverage and price risk.
Leverage is a tool that allows you to borrow funds from your broker to increase your position beyond what is available in your balance. This has the potential to lead to significant gains or substantial losses because of market volatility.
As the prices of commodities fluctuate, the traders either lose money or make money.
Your broker will provide all the relevant information and advise you on risk management strategies before entering the market.