We’ll teach you to start commodity trading today…
The commodities market is one of the foundations of the global trade system. For the serious trader, a knowledge in how to trade commodities is vital: great profits can be made if a trader has in-depth expertise in the issues driving commodity prices, and understands the mechanics of how to trade on it.
The advent of online commodity trading means that access to global markets is now available to private traders with a modest amount of capital thanks to accessible online brokers.
What are Commodities?
A commodity is a basic good or raw material in commerce that individuals or institutions buy and sell. Commodities are often the building blocks for more complex goods and services.
What separates commodities from other types of goods is that they are standardized and interchangeable with other goods of the same type. These features make commodities fungible. This means that two equivalent units of the same commodity should have mostly uniform prices any place in the world (* excluding local factors such as the cost of transportation and taxes).
Generally, commodities are extracted, grown, produced and traded in large enough quantities to support liquid and mostly efficient global trading markets. These markets provide a transparent way for commodity producers, consumers and financial traders to transact business. Examples of commodities include corn, wheat, copper and oil.
How Did Commodities Evolve?
Commodities trace their origins to the beginning of human civilization, although the precise timing and location is the subject of debate.
Evidence suggests that rice may have been the first commodity since the Chinese began trading it about 6,000 years ago.
In 4,500 and 4,000 BC, the Sumerian civilization (* the region that is now modern-day Iraq) began using clay tokens as a primitive form of money to purchase livestock.
Buyers would place these tokens in sealed clay vessels and record the quantities, times and dates of the transactions on writing tablets. In exchange for the vessels, merchants would deliver goats to the buyers. These transactions constituted a primitive form of commodity futures contracts. Other civilizations soon began using valuable such as pigs and seashells as forms of money to purchase commodities.
Eventually, however, the ancient Greeks and Romans settled on gold and silver as the favored currencies for transacting business in commodities. These civilizations prized gold and silver for their luster and physical beauty. In addition, since gold and silver are rare and can be melted, shaped and measured into coins of equal size, they logically evolved into monetary assets. Ultimately, exchanging gold for goods and services became the preferred means of commerce in the ancient world and led gold to become the first widely traded commodity.
In the United States, grain commodities first developed in the 19th century in response to the food needs of the nation. The latter part of the 20th century saw the commoditization of other agricultural products including livestock and the development of metals and energy commodities.
What Are the Main Commodities?
Commodities can generally be divided into four categories:
- Agricultural: This category includes food crops (e.g., corn, cotton and soybeans), livestock (e.g., cattle, hogs and pork bellies) and industrial crops (e.g., lumber, rubber and wool)
- Energy: These include petroleum products such as crude oil and gasoline, natural gas, heating oil, coal, uranium (used to produce nuclear energy), ethanol (used as a gasoline additive) and electricity
- Metals: Precious metals (e.g., gold, silver, platinum and palladium) and base metals (e.g., aluminum, nickel, steel, iron ore, tin and zinc)
- Environmental: This category includes products such as carbon emissions, renewable energy certificates and white certificates
Although the four categories contain dozens of traded commodities, the following generate the most liquidity (trading) in financial markets:
Coffee: The global coffee industry is enormous. In the United States alone, it accounts for more than 1.6% of GDP and an estimated 1.7 million jobs. As a commodity, coffee is intriguing for at least two reasons. The overwhelming supply of the commodity derives from just five countries. At the same time, global demand for coffee continues to grow as emerging market economies develop a taste for the beverage.
Corn: Corn is a commodity with several important applications in the global economy. It is a food source for humans and livestock as well as a feedstock used in the production of ethanol fuel. The high cost of sugar in the United States has made corn a key ingredient in sweetening products such as ketchup, soft drinks and candies. Growing food and fuel demand globally should drive continued interest in corn as a commodity.
Sugar: Sugar is not only a sweetener, but it also plays an important role in the production of ethanol fuel. Historically, governments across the world have intervened heavily in the sugar market. Subsidies and tariffs on imports often produce anomalies in prices and make sugar an interesting commodity to trade. Although sugar cane is grown all over the world, the ten largest producing countries account for about three-quarters of all production.
Soybeans: Soybeans play a critical role in the global food ecosystem. The oil from the crop is used in many products including bread, crackers, cakes, cookies and salad dressings, while the meal from crushed soybeans serves as the main source of food for livestock. Soybean oil also serves as a feedstock in the production of biofuels. The growing need for food and fuel in emerging market economies could drive demand for soybeans. Three countries – the United States, Brazil and Argentina – account for 80% of global production.
Wheat: Wheat grows on six continents and for centuries has been one of the most important food crops in the world. Traders compare wheat prices to other grains such as corn, oats and barley. Since these commodities can be substituted for one another, changes in their relative prices can shift demand between them and other products such as soybeans. Demand for cheap and nutritious food sources in developing nations should continue to drive interest in the wheat market.
Crude Oil: This commodity has the largest impact on the global economy. Not only is crude oil used in a variety of forms of transportation including cars, trains, jets and ships, it is also used in the production of plastics, synthetic textiles (acrylic, nylon, spandex and polyester), fertilizers, computers, cosmetics and more. If you take into account the input cost of transportation, crude oil plays a role in the production of virtually every commodity.
Crude oil has different variations based on geography and physical characteristics: West Texas Intermediate (WTI), also known as light sweet crude, and Brent Crude are two of the most frequently traded varieties.
Natural Gas: Natural gas is used in a variety of industrial, residential and commercial applications including electricity generation. It is considered a clean fossil fuel source and has garnered increasing demand from more countries and economic sectors. The United States and Russia have emerged as the leading producers of this important global commodity.
Gasoline: The main use of this refined crude oil product is as a source of fuel for cars, light-duty trucks and motorcycles. Gasoline prices can have an enormous effect on the overall economy since demand for the commodity is generally inelastic. That is, consumers need to put gasoline in their vehicles to go to work, school and other essential activities. Many traders trade crack spreads, which are the differences between crude oil prices and the price of refined crude products such as gasoline.
Gold: Gold is a fascinating commodity because so much of the demand for it derives from speculators. Many market participants see gold as an alternative to paper money, so the price of the commodity often moves in opposite direction from the dollar. Gold is also used to make jewelry and electronics.
Silver: Many market participants view silver as the poor man’s gold. It too receives significant demand from speculators as well as from jewelry and other industries. Traders track the ratio between gold and silver prices since historically this relationship has been an indicator of the relative value between the two metals.
Copper: Copper has so many industrial uses that it would be virtually impossible to build the infrastructure of a country without it. Traders often refer to the commodity as Dr. Copper. They say the metal has a Ph.D. in economics because its price is a reliable barometer of the overall health of the global economy. In fact, investing in copper is a way to express a bullish view on world GDP.
The term cryptocurrency covers a broad variety of digital tokens that can serve a number of different purposes. A traditional cryptocurrency like Bitcoin is designed to act as a form of digital currency and a store of value. Others like Ripple or Ethereum are designed fulfill a specific purpose and are targeted at specific niches.
The vast majority of cryptocurrencies take advantage of blockchain technology. In their most simple form they use cryptography to process transactions and create new coins, this process is usually performed by computers solving complex equations and is called mining. All processed transactions are stored on the blockchain which acts as a giant computerized ledger.
This ledger can be shared simultaneously across thousands of computers and acts as an immutable record of all transactions that have ever taken place on the blockchain. This basic technology acts as the foundation for more advanced features such as smart contracts.
Cryptocurrencies are popular because their decentralized nature allows for enhanced security and privacy. Many users also believe that it helps to protect them from the interference of Governments and could help to break the monopoly on money currently enjoyed by the banking sector.
Bitcoin is the most well known cryptocurrency but there are hundreds of different cryptocurrencies, known as altcoins. These altcoins range from mere Bitcoin clones to currencies like Ripple or NEO built with specific utilities in mind.
Are cryptocurrencies really commodities?
Cryptocurrencies are a unique sort of asset and defy easy classification. Many argue that cryptocurrencies and Bitcoin are currencies. This assessment makes sense given Bitcoin’s ambitions to supplant fiat currencies. The problem with this assessment is that it ignores the fact that centralization and government interference are one of the key features of a currency. Governments and banks regularly manipulate their own currencies in order to maintain favourable market positions and would be unable to do this using Bitcoin.
Some newer cryptocurrencies can be considered something closer to securities. Indeed, the Swiss Financial Market Supervisory Authority (FINMA) has published guidelines on Initial Coin Offerings or ICOs breaking them into three categories. Many ICO tokens act as something akin to shares in a company and FINMA plans to regulate them under the same rules.
Given the sheer variety of cryptocurrencies you can’t define all of them as securities or all of them as currencies. Instead a much better analogue for cryptocurrencies are real-world commodities, indeed Bitcoin is often referred to as “digital gold” and many cryptocurrencies are “mined” by computers. A commodity is normally free from outside control, barring regulations, and their value is determined by market factors.
Commodities generally have three main purposes. They are either meant to be used, speculated upon or traded for goods. Bitcoin can’t necessarily be used but it is certainly considered to be a speculative asset by the majority of traders and its advocates want to be able to exchange Bitcoin for goods and services. Indeed Bitcoin has become a bartering tool in Venezuela where the collapsing value of the Bolivar has led to people seeing Bitcoin as a safe haven.
Given the sheer variety of cryptocurrency and the fact that most can be used in one of the three ways that a commodity can be used we believe that they are best classified as a commodity. We have selected some of the most promising market leaders in the cryptocurrency world today and created detailed breakdowns of what they do, how they work and the way to invest in them.
- Bitcoin is a decentralized digital currency and is currently the most valuable and most well-known cryptocurrency.
- Bitcoin Cash is a hard fork of Bitcoin designed to process larger numbers of transactions simultaneously than its predecessor.
- Litecoin is created to be the silver to Bitcoin’s gold and improves on the Bitcoin concept in many ways. It has been tailored for smaller transactions than Bitcoin.
- Ethereum is a smart contract platform that allows developers to create specialized cryptocurrencies, most ICOs are built using Ethereum.
- Ripple is designed to operate as a blockchain solution that enables banks and payment providers to facilitate more efficient cross-currency transactions.
- Monero provides its users with enhanced privacy by using stealth addresses and untraceable transactions.
- Dash uses a unique master-node based consensus system to allow instant payment and private transactions.
- NEO takes advantage of smart contracts to build the “smart economy” of the future.
- Verge takes the advantages of other privacy based coins and attempts to make them convenient for the everyday user.
- Zcash uses a shielded pool in order to protect the privacy of its users.
What are the Main Drivers of Commodity Prices?
Each individual commodity has unique factors that drive its price. However, certain common factors play a role in determining prices for most commodities:
- Emerging Market Demand
- The US Dollar
Emerging Market Demand
Fast-growing countries such as India and China are accumulating vast amounts of wealth as their economies grow. As a result, they have a growing need for a variety of basic goods and raw materials such as crops and livestock to feed their people, metals to build the infrastructure in their cities and energy to fuel their factories, homes and farms. Demand from emerging markets has a huge impact on commodity prices. Signs of economic slowdown in these countries can depress prices, while surging economic growth can cause commodity prices to rise.
The relative scarcity or abundance of commodities can cause large movements in their prices. In the case of agricultural commodities, for example, the size of the annual crop yield can move market prices. Other factors that can affect supply include political, environmental or labor issues in major producing countries. For example, environmental regulations might lead to the closure of mines, and metal prices could rise in response to this supply shortfall. Inventory levels could also impact the available supply of commodities. If major consumers of commodities build up inventory levels, then the market might see the increased supply as an overhang on prices. On the other hand, depletion of inventories could create the perception of a supply shortfall and cause prices to rise.
As the world’s reserve currency, the dollar can often dictate the direction of commodity prices. When the value of the dollar drops against other currencies, it takes more dollars to purchase commodities than it does when the price is high. Put another way, sellers of commodities get fewer dollars for their product when the dollar is strong and more dollars when the currency is weak. Factors such as weak employment or GDP numbers in the United States can weaken the dollar and lead to higher commodity prices, while strong economic numbers can weaken commodity prices.
The economic principle of substitution creates a risk of investing in any commodity. As prices for a particular commodity climb, buyers will seek cheaper substitutions, if available. For example, cheaper metals such as aluminum often substitute for copper in many industrial applications. Similarly, farmers may substitute between corn, oats, wheat and barley as livestock feed based on price.
Weather can play an important role in determining many commodity prices. In the agricultural sector, prolonged drought conditions or excessive rainfall can limit crop yields and cause prices to rise. In the energy sector, hurricanes, storms or extremely cold weather can curtail drilling or refining activity and create supply shortfalls. Severe winter weather can create excessive demand for heating and cause big increases in prices of commodities such as natural gas and heating oil. Extremely warm weather, on the other hand, could raise demand for electricity needed to power air conditioning units.
Why Should You Trade Commodities?
There are a number of reasons to trade commodities including:
- Population Growth
- Inflation Hedge
- Portfolio Diversification
Increases in the world population and demographic shifts could create investment opportunities in all classes of commodities.
The World Economic Forum estimates that the number of people living in cities could reach 6.4 billion by 2050. This trend should create enormous demand for metals as cities build their infrastructure.
Not only will population increase, but people will be richer. The greatest gains in wealth will be in emerging market economies in Asia and Africa. These wealthier countries will demand agricultural products such as grains and livestock to feed their citizenry and cotton and wool to clothe them.
Population growth will also stoke demand for energy commodities. As people in the developing world migrate from rural areas into cities, demand for energy will rise. Nearly 1.3 billion people in the world have no access to electricity, including about one-quarter of the population of India. Urbanization and economic growth will also create new demand for fossil fuels to power cars, homes and businesses.
Investing in commodities one way to protect against inflation. Virtually all commodities could become more expensive if world economies experience bouts of inflation.
Overly accommodative monetary policies from the world’s largest central banks have kept global interest rates low and created speculation in many different asset classes. At some point, this speculation could show up in commodity markets. A weak dollar, in particular, could create inflation and lead to higher commodity prices.
Most traders have the vast majority of their assets in stocks and bonds. Commodities provide traders with a way to diversify and reduce the overall risk of their portfolios.
How Did the Commodities Markets Evolve?
According to commodity historian, Bruce Babcock, the first formally recorded commodity futures trades probably occurred in 17th century Japan. (* However, some might argue that the Sumerian clay vessels or ancient Chinese rice trades constituted formal commodities futures contracts.)
Most historians agree, though, that the adoption of gold coins as a medium of exchange in medieval Europe played a key role in the development of commodity markets. Regions throughout Europe began making their own specialized gold coins and trading with merchants returning from the East Indies and Asia. These developments led to the need for centralized exchanges.
The first stock exchange formed in Belgium around 1531, and by the early 1600s, the Dutch, British and French governments began chartering companies to invest in voyages to the East Indies and Asia. The goal of these trips was to bring back spices, silk and other treasures. However, the sailors faced risks including Barbary pirates, bad weather and poor navigation. To diversify their risks, traders would bet on several voyages at the same time. A separate limited liability company financed each voyage, and together they formed the first commodity company investments.
What are Forward and Futures Markets?
In the 1800s, the burgeoning grain trade led to the establishment of commodities forward contract markets in the United States. Farmers in the Midwest would bring their crops to Chicago for storage prior to shipment to the East Coast. However, during storage, the prices for these grains might change for a variety of reasons. The quality of the stored item could deteriorate, for example, or demand for the item could increase or decrease.
To allow buyers and sellers to lock in transaction prices prior to delivery, the parties created forward contracts. These contracts bound the seller to deliver an agreed-upon amount of the grain in question for an agreed-upon price at an agreed-upon date. In exchange for this obligation, the seller would receive payment upfront for the grains. These contracts are called forward contracts. They trade in the over-the-counter market, which means the contracts are privately negotiated between two parties. The buyer faces the risk that the seller might default on the contract and fail to deliver the asset.
As more farmers began delivering their grains to the warehouses in Chicago, buyers and sellers realized that customized forward contracts were cumbersome and inefficient. Furthermore, they subjected the buyer to the risk of default by the seller. A group of brokers streamlined the process by creating standardized contracts that were identical in terms of the (a) quantity and quality of the asset being delivered, (b) the delivery time and (c) the terms of the delivery. They also created a centralized clearinghouse to act as the counterparty to both parties in the transaction. This eliminated the risk of default that was present with forward contracts. In 1848, they established the Chicago Board of Trade (CBOT) to trade these contracts, which became known as futures contracts.
Comparison of Forward and Futures Contracts
|Contract Terms||Privately negotiated between the two parties||Standardized|
|Method of Trading||Over-the-counter: The two parties enter into a bilateral agreement and must enforce the terms of the contract, including any requirements to post margin (additional funds).||Financial exchange: The exchange acts a clearinghouse for the trade and requires all participants to post margin as the price of the contract fluctuates.|
|Counterparty Risk||High||Virtually none|
|Secondary Market||Essentially none||Yes. Since contracts are standardized and backed by an exchange, traders can easily transfer their risk to other market participants.|
How Did Modern Futures Trading Evolve?
In the 100 years following the establishment of the CBOT, agricultural products remained the primary commodities traded on futures exchanges. In 1936, the CBOT added soybeans, and in the 1940s, cotton and lard trading commenced. By the 1950s, livestock futures began trading, and the 1960s saw the introduction of precious metals trading.
However, beginning in the 1970s, new financial products began to take shape. The decision by the United States to end the pegging of the dollar to the price of gold produced a free-floating currency system. In other words, supply and demand, not artificial pegs, determined how much each currency was worth. This produced new markets in foreign exchange trading.
The idea of trading prices, as opposed to physical goods, eventually made its way to other markets. In 1981, the Chicago Mercantile Exchange (CME) launched the first cash-settled futures contract on the Eurodollar. Essentially, upon expiration of a cash-settled futures contract, the seller of the contact does not physically deliver the underlying asset but instead transfers the associated cash position. Once the US Commodities Futures Trading Commission (CFTC) approved the Eurodollar futures contract, exchanges began listing cash-settled futures contracts on traditional commodities.
By the 1980s and 1990s, futures trading expanded to stock market benchmarks such as the S&P 500.
The 21st century ushered in the era of online trading. Soon electronic marketplaces replaced physical trading floors. These developments may have had the biggest impact on commodities futures markets since commodities trading became available to millions of people around the globe. Today dozens of countries around the world operate commodities futures exchanges.
What Are the Top Global Commodities Exchanges?
|Chicago Mercantile Exchange (CME)||1898||This American financial and commodity derivatives exchange offers one of the largest menus of futures and options contracts of any exchange in the world.||Began as the Chicago Butter and Egg Board, a dairy exchange.|
|Chicago Board of Trade (CBOT)||1848||A subsidiary of the CME Group since 2007, the CBOT offers more than 50 different futures and options across several asset classes.||Oldest futures and option trading exchange in the world.|
|New York Mercantile Exchange (NYMEX)||1882||The world’s largest physical commodity exchange, the NYMEX was acquired by CME Group in 2008.||Operates Commodity Exchange, Inc., (COMEX), a leading metals exchange.|
|Intercontinental Exchange (ICE)||2000||US-based electronic exchange that focuses on global commodities futures markets and cleared OTC products.||Began as an exchange focused on energy markets.|
|London Metals Exchange (LME)||1877||UK-based exchange that offers futures and options trading primarily on base metals.||Although formally founded in 1877, the exchange traces its origins back to the reign of Queen Elizabeth I in 1571.|
|Australian Securities Exchange (ASX)||1987||Australia’s primary securities exchange, ASX offers futures and options markets on agricultural, energy and electricity commodities.||ASX merged with the Sydney Futures Exchange in 2006.|
|Tokyo Commodity Exchange (TOCOM)||1984||The largest futures exchange in Japan, TOCOM trades precious metals, energy and agricultural products including rubber.||Formed from merger of the Tokyo Textile Exchange, Tokyo Gold Exchange and Tokyo Rubber Exchange.|
What Are the Different Ways to Invest in Commodities?
Depending on the particular commodity, traders have several ways to gain exposure to commodity prices:
Investors can physically purchase commodities and store them. For commodities that perish (e.g., corn, wheat and soybeans) or require special handling (natural gas or uranium) this method is impractical.
However, some commodities such as precious metals lend themselves to physical purchase.
Physical bullion such as bars or coins is the most direct way to invest in precious metals. Investing in bullion requires a secure storage facility. Some precious metals such as silver have such a low value-to-weight ratio that storing them might be too expensive and impractical.
Futures are a derivative product that allows traders to gain exposure to commodity prices without physically taking possession of the asset. With these contracts, traders agree to purchase a certain amount of a commodity at a date in the future (the expiration date). The trader pays for the contract at the time of purchase. If prices rise between the purchase date and the expiration date, the trader will profit, whereas if prices fall, the trader will lose money.
Most futures markets offer generous leverage to traders. As a result, traders only have to put up a small fraction of the value of the contract when buying. This can produce great returns if the price of the commodity moves higher. However, if the price moves lower, the trader must put up additional margin to cover the risk of the investment.
Investing in futures requires a high level of sophistication since factors such as storage costs and interest rates affect pricing.
Options on Futures
Options on futures are another derivative instrument that employs leverage to invest in commodities. There are two types of options: calls and puts.
An owner of an option contract has the right but not the obligation to buy (in the case of a call option) or sell (in the case of a put option) a particular futures contract at a specific price (the strike price) on or before a certain date (the expiration date).
In other words, an option buyer can exercise a right to take a position in the futures market at or before expiration. If the option is a call, the trader can exercise the right to go long the futures contract. If the option is a put, the trader can exercise the right to go short the futures contract.
An options purchase will be profitable only if the price of the future exceeds the strike price (in the case of a call) by an amount greater than the premium paid for the contract. For a put purchase to be profitable, the price of the future must fall below the strike price by an amount greater than the premium paid for the put. Therefore, options buyers must be right about the size as well as the timing of the move in futures to profit from their trades.
Comparison of Calls and Puts
|Call Buyers||Call Sellers|
|Premium||Pay premium||Collect premium|
|Exercise||Have the right (but not the obligation) to exercise the option into a long futures position.||Have the obligation, if assigned, to assume a short futures position.|
|Time Decay||Time decay works against them.||Time decay works in their favor.|
|Margin Requirements||No margin performance requirements.||Have performance margin requirements.|
|Put Buyers||Put Sellers|
|Premium||Pay premium||Collect premium|
|Exercise||Have the right (but not the obligation) to exercise the option into a short futures position.||Have the obligation, if assigned, to assume a long futures position.|
|Time Decay||Time decay works against them.||Time decay works in their favor.|
|Margin Requirements||No margin performance requirements.||Have performance margin requirements.|
ETFs are financial instruments that trade as shares on exchanges in the same way that stocks do. Some ETFs invest in commodity futures or options on futures, while other ETFs invest in shares of companies that produce the particular commodity. Still, others invest in physical commodities such as bullion.
While ETFs may seem like perfect proxies for investing in commodities, traders should be aware of their risks and costs.
ETFs that invest in physical commodities, futures or options on futures come with the same risks and rewards that individual investments in these products do (see above). For example, an ETF that invests in bullion would incur the same storage and security costs that individual traders do. Ultimately, these costs get passed on to the ETF trader.
As for ETFs that invest in shares of companies that produce commodities, they come with the same risks and rewards of investing in individual shares (see below).
Commodity shares can be an effective way to make a leveraged bet on commodity prices. Commodity producers often have large initial capital costs to develop, explore and produce resources. Later in their development, they have mostly fixed costs such as salaries, rent and debt servicing.
However, commodity producers always have variable revenues that depend on the price of the commodity they are selling. In theory, then, investing in commodity companies is a way to make a leveraged bet on the price of the particular commodity. As the commodity’s price rises, more revenues should flow to the bottom line in the form of profits.
However, many factors other than commodity prices can affect the performance of commodity company share prices:
- Production costs: A rise or fall in the cost of wages or equipment, for example, affects profits.
- Competition: The strength of competitors can affect the profitability of commodity producers.
- Interest rates: Changes in interest rates can affect the cost of debt servicing. This factor is especially important to mining, energy and utility companies with huge infrastructure financing costs.
- Local Economies: The relative strength of the economy where a company sells its products can impact its profits.
- Multiple Contraction or Expansion: The market assigns price/earnings multiples to companies based on perceptions of future prospects. Changes to these multiples can cause fluctuations in share prices.
Contracts for Difference
Contracts for Difference (CFDs) are another derivative instrument that can be used to invest in commodities markets. A CFD is basically a contract between a trader and a brokerage firm. At the end of the contract, the two parties exchange the difference between the price of the asset at the time they entered into the contract and its price at the end of the contract.
Many regulated brokers worldwide offer CFDs on both commodities and the shares of commodity producers. Customers deposit funds with the broker, which serve as margin. The advantage of CFDs is that trader can have exposure to commodity prices without having to purchase shares, ETFs, futures or options.
Regulated brokers include:
CFD brokers usually offer generous leverage to traders.
As with futures and options, leverage works both ways. It can enhance returns or force traders to post additional margin periodically to maintain positions.*
*Important: CFDs are complex instruments and come with a high risk of losing money rapidly due to leverage. Between 74-89% of retail trader accounts lose money when trading CFDs. You should consider whether you understand how CFDs work and whether you can afford to take the high risk of losing your money.
How Can I Profit from Trading Commodities?
As with stock and bonds, speculators in commodities markets look to buy an asset at a low price and sell it at a higher price. However, commodity trading is different from stock and bond trading in three important ways:
- Leverage: Futures markets – the most liquid products for trading commodities – offer traders much more leverage than stock and bond markets. Increased leverage can produce both bigger gains and bigger losses.
- Volatility: Commodities can be much more volatile than stocks and bonds. Many of the factors that impact supply and demand for commodities can be very challenging to predict (e.g., weather, political unrest, labor strikes, crop infestations, etc.). When these factors change, commodity markets can produce sudden and abrupt price adjustments.
- Fundamentals: Stock and bond markets have fundamental data points that drive price action. Price/earnings ratios, interest rates, credit ratings and debt/equity ratios are some of the financial metrics traders use to price stocks and bonds. Commodities, on the other hand, have few if any such reliable metrics. Price action is usually driven by short-, intermediate- or long-term market sentiment. As a result, analyzing commodities markets is much more difficult.
Given these challenges, one might conclude that commodity trading is no different than betting on a roulette wheel at a casino! However, this is not the case. With the right approach, commodities investments can be a profitable addition to an investment portfolio.
Traders of all levels should begin with an understanding of the importance of these four items:
- Position Sizing
- Risk Management
The fact that commodities don’t have obvious fundamental data points is a hindrance, but it’s also an opportunity.
Researching trends and developing an understanding of the factors that move commodity markets takes considerable time and thorough research skills. Unlike stocks and bonds, the information needed to make investment decisions is often scattered in many places. Successful commodity traders are avid readers and avail themselves of information found in scholarly articles, government websites, trade publications, the Farmers’ Almanac, charting software and other sources relevant to their market.
Many traders are attracted to commodity markets because of the extensive leverage they offer. However, excessive leverage is the main reason that more than 98% of new commodity traders lose money.
Traders should examine long-term charts to assess the historical price ranges of individual commodities. They should then use these charts as a guide to calculate worst-case scenarios. Ultimately, they should enter positions in sizes small enough to enable them to make margin calls if positions move against them.
Sometimes the best-researched ideas simply don’t pan out the way we expected. Unfortunately, many novice traders hold on to losing positions and hope that the positions will return to profitability. This focus on increasing profits as opposed to limiting losses is a major mistake that traders at all levels must learn to avoid.
One way to avoid this problem is to place disciplined stops on commodity trades. A stop is a level below which a trader exits a long position. Using hard stops on trades is a way to ensure that small losses don’t turn into big losses.
Purchasing a basket of commodities helps protect traders from the volatility of any individual commodity. It also adds overall diversification to a stock and bond portfolio.
Investing in a basket of commodities that can accomplish three goals:
- It can provide protection against inflation
- It can add diversification to a portfolio that is heavily invested in financial assets
- It can protect a trader from the volatility of movements in individual commodities
What Trading Strategies Do Commodity Traders Use?
There are many commodity trading strategies, and the particular ones a trader chooses often depend on the trader’s skill level. Most strategies fall generally into one of two categories:
Fundamental Analysis: This strategy makes trades based on the underlying economic factors that determine the value of an asset. Traders that use fundamental analysis need to develop a keen understanding of the factors that influence the supply and demand picture for a particular commodity. Supply and demand are opposing forces. Rising demand positively impacts prices, while rising supply negatively impacts prices
Technical Analysis: This strategy uses historical prices and charts to analyze trends. Technical analysis traders believe historical price trends have predictive ability for prices in the future. They look for price points in the past where significant buying or selling occurred. They then place orders to trigger positions once those price levels occur again. Pure technical analysis traders pay no attention to fundamental economic factors in their trading.
Traders with limited or no previous experience with commodity markets should stick to the most basic strategies for assessing markets. In the case of fundamental analysis, this means paying attention to these items:
Production Levels: Beginning traders should look for broad trends in the output of individual commodities. Patterns in the level of crops being produced, metals being mined and oil being drilled can offer clues about the direction of markets.
- Inventories: As with output, inventory levels can be a great fundamental investment tool. Persistent drawdowns in inventories often accompany higher prices, while inventory buildups usually lead to price declines.
- Macroeconomic data: Beginning traders should monitor trends in GDP, unemployment and retail sales for clues about the strength of the economy. Strong data often coincides with rises in industrial commodity prices, while weak data can lead to lower prices.
Beginning technical analysis traders should familiarize themselves with the following charts:
- Line Charts: This is the most basic chart. It shows the price of the commodity on the y-axis and the date on the x-axis. Beginning traders should familiarize themselves with charting different time horizons such as hourly, daily and weekly. Each of these charts can provide information about entry points and the length of time to hold an asset.
- Candlestick Charts: These charts show the open, high, low and closing prices for each period being graphed. The graphical representation of this data is in the form of elongated bars known as candlesticks. Technical analysis traders analyze the shape of candlesticks to predict future prices.
Traders with some experience can begin to incorporate more complex data into their trading strategies.
Intermediate-level fundamental traders may want to delve deeper into the end markets for particular commodities. For example, strength or weakness in the commercial real estate markets in large metropolitan areas can offer clues about demand for steel and other industrial metals. Similarly, the Cattle on Feed Report released by the USDA shows the future supply of cattle coming on to the market and can offer clues about future beef prices. Once traders become familiar with interpreting the significance of these data points, they can use them to make trading decisions.
Intermediate-level technical analysis traders can begin to incorporate more sophisticated charting tools into their trading decisions:
- Uptrends: A series of higher highs and higher lows on charts indicates a bullish trading pattern.
- Downtrends: A series of lower highs and lower lowers on charts indicates a bearish trading pattern.
Traders can use charting software to draw trend lines on charts and identify these patterns.
Another strategy intermediate-level technical traders might employ is to compare charts of different assets. For example, oil and stocks enjoy a very high historical price correlation. If one of these markets is making a series of higher highs, then traders might expect the other market to follow suit.
Experienced traders employ the most sophisticated trading strategies. For fundamental traders, these include the following:
- Bull and Bear Cycle Analysis: Identifying long-term secular trends in markets can produce the largest profits of any trading strategies. Experienced traders look at the pricing of individual commodities compared to their long-term average prices. Disparities in these two values often presage the beginning of long-term bull or bear markets.
- Broad Policy Assessment: Actions by central banks can presage movements in commodities prices. For example, a period of prolonged easing by major central banks often leads to higher commodity prices, while a series of rate hikes often produces bear markets.
- Major Commodity Analysis: The price action of major commodities such as oil and gold often precedes movement in lesser commodities. For example, a prolonged uptrend in oil prices might be a good reason to invest in other fossil fuels such as natural gas.
- Production Output: Sophisticated traders examine the output of leading producers for clues about big economic cycles. For example, mining companies might close mines and reduce output when metals prices are depressed. However, these actions often indicate that a market bottom is forming. Using production output from leading producers as a contrary indicator can be a profitable trading strategy.
- Kondratiev Waves: This technique makes long-term predictions of commodity prices based on economic cycles.
Experienced technical analysis traders also rely on more sophisticated strategies:
- Moving Averages: This strategy takes the average closing price for a certain number of periods and then graphs this information as a line above the price chart. When commodity prices trade through moving average levels, they can signal the direction of future prices.
- Breakouts: Traders chart resistance and support levels on charts based on historical levels. Breaches of resistance levels generally indicate a move higher for prices, while breaches of support levels often indicate lower prices.
- Fibonacci Analysis: Fibonacci analysis predicts retracement levels for commodity prices. Traders use these levels, which are derived from number sequences, to predict the resumption of uptrends or downtrends in commodity prices.
- Commodity Channel Index (CCI): This powerful technical indicator generates buy and sell signals for commodities based on how overbought or oversold they are. The indicator is designed to profit from changes in price trends.
Although many traders consider themselves either fundamental or technical traders, this distinction need not hold in every case. The very best traders incorporate elements of both forms of analysis in their trading. For example, a trader may see production figures for gold dwindling. At the same time, the trader notices that the CCI indicates that gold is oversold. The confluence of these two indicators may be a perfect signal to buy gold.