Commodity Trading: Learn How To Trade Oil, Gold & Much More


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Many people find commodities trading alluring because of the vast sums of money involved.

But it is no get-rich-quick scheme. Like any kind of speculation, it is a skill that requires knowledge, talent, and dedication. Even then, it's extremely risky.

Below, we explain the basics of commodity trading: investment vehicles, necessary tools, and strategies. This will provide you with a basic understanding of the field.

But there's so much more to learn. Our website is filled with important information about different commodities, trading information, and the low-down about the major online brokers.

Want to get started? Read on.

What Are the Different Ways to Trade in Commodities?

Investors have several ways to gain exposure to commodity prices:- physical delivery, futures, options, ETFs, Shares and CFDs.

Physical Delivery

Traders can buy commodities and store them. For commodities that perish (eg, corn, wheat, and soybeans) or require special handling (natural gas or uranium) this method is impractical.

But some commodities such as precious metals lend themselves to physical storage.

Bullion such as bars or coins is the most direct way to trade in precious metals. It just 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 costly.

Futures

Futures are a derivative that allows traders to invest in commodities without physically taking possession of the asset.

Traders agree to buy a certain amount of a commodity at a date in the future (the expiration date). They pay for the contract at the time of purchase. If prices rise before the expiration date, there is a profit. If prices fall, there is a loss.

Most futures markets offer leverage to traders. As a result, traders only have to put up a small fraction of the value of the contract at first. This can produce great returns if the price of the commodity moves higher. It can also lead to big losses that the trader must then put up.

Trading 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 leveraged derivative. 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 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. If the option is a put, the investor can exercise the right to go short.

An option 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.

Calls Summary

 Call BuyersCall Sellers
Premium Pay premiumCollect premium
ExerciseHave 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 DecayTime decay works against them.Time decay works in their favor.
Margin RequirementsNo margin performance requirements.Have performance margin requirements.

For a put purchase to be profitable, the price of the future must fall below the strike price by more than the premium paid for the put.

Options buyers must be right about the size as well as the timing of the move in futures to profit from their trades.

Puts Summary

 Put BuyersPut Sellers
Premium Pay premiumCollect premium
ExerciseHave 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 DecayTime decay works against them.Time decay works in their favor.
Margin RequirementsNo margin performance requirements.Have performance margin requirements.

Commodity ETFs

ETFs (exchange-traded funds) 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. Other ETFs invest in shares of companies that produce a 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. These costs get passed on to the ETF investor.

As for ETFs that invest in shares of companies, they come with the same risks and rewards of investing in individual shares (see below).

Commodity Shares

Commodity shares are a way to make a leveraged bet on commodity prices. Producers often have large initial costs to develop, explore, and produce resources. Later in their development, they have fixed costs such as salaries, rent, and debt service.

However, commodity producers always have variable revenues that depend on the price of the commodity they are selling.

In theory, then, investing in these companies is a way to make a leveraged bet on the price of the commodity. As the commodity’s price rises, more money should flow to the bottom line in the form of profits.

But many other factors affect the performance of a company's 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 profitability.
  • Interest rates: Changes in interest rates can affect the cost of debt servicing. This factor is especially big in mining, energy and utility.
  • 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 multiples to companies based on perceptions of future earnings. Changes to these can change share prices.

Contracts for Difference

Contracts for Difference (CFDs) are derivative instruments that can be used to trade in commodities markets.

A CFD is 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 of the contract and the end of the contract.

IMPORTANT: CFDs are not available in the USA due to local regulation, and these regulated CFD brokers do not accept US citizens or US residents as clients.

Many regulated brokers offer CFDs on both commodities and the shares of producers. Customers deposit funds with the broker, which serve as margin.

One key advantage of CFDs is that the trader can have exposure to commodity prices without having to purchase shares, ETFs, futures, or options.

Popular CFD Brokers

What You Need to Be a Successful Commodities Trader

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. But commodity trading is different from stock and bond trading in three important ways:

  1. 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.
  2. Volatility: Commodities can be much more volatile than stocks and bonds. Many of the factors that impact supply and demand for commodities can be hard to predict (eg, weather, social unrest, labor strikes, crop failures, etc.). When these factors change, commodity markets can suffer abrupt price changes.
  3. Fundamentals: Stock and bond markets have fundamental data points that drive prices. Price/earnings ratios, interest rates, credit ratings, and debt/equity ratios are some of the metrics traders use to price stocks and bonds. Commodities, on the other hand, have few if any such reliable metrics. Prices are 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. But with the right approach, commodities can be a profitable addition to a portfolio.

Traders of all levels should begin with the importance of these four items:

  1. Education
  2. Position Sizing
  3. Risk Management
  4. Diversification.

Education

The fact that commodities don’t have obvious fundamental data points is a hindrance, but it’s also an opportunity.

Researching trends and learning the factors that move commodity markets takes time and effort. The information needed to make trading decisions is often scattered in many places.

Successful commodity traders are avid readers and use information found in scholarly articles, government websites, trade publications, the Farmers' Almanac, charting software, and other sources.

Trading Platform Charts and Graphs
Trading platforms feature charts and graphs to help with decision making by PIX1861 under Pixabay License.

Position Sizing

People trade commodities because of the leverage that can be used with them. But leverage is the main reason that more than 98% of new commodity traders lose money.

Traders should research assess the historical price ranges of commodities. They should then use this data as a guide to calculate worst-case scenarios. They should enter positions in sizes small enough to enable them to make margin calls if markets move against them.

Risk Management

Sometimes the best-researched ideas simply don’t pan out the way we expect. Many novice traders hold on to losing positions and hope that they will return to profitability. This focus on increasing profits rather than 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.

Diversification

Purchasing a basket of commodities helps protect traders from the volatility of any individual commodity. It also adds diversification to a stock and bond portfolio.

Investing in a basket of commodities can accomplish three goals:

  1. It can provide protection against inflation
  2. It can add diversification to a portfolio that is heavily invested in financial assets
  3. It can protect a trader from the volatility of movements in individual commodities.

What Strategies Do Commodity Traders Use?

There are many commodity trading strategies. Those 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 economic factors that determine the value of an asset. Traders that use fundamental analysis need to develop a keen eye for the supply and demand picture for a particular commodity. Supply and demand are opposing forces. Rising demand positively impacts prices; rising supply negatively impacts prices

Technical Analysis: This strategy uses historical charts and data to analyze trends. Traders who use this strategy think historical price trends have predictive value 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 factors in their trading.

Trading Analysis
Traders look at historical commodity prices to conduct their trading analysis (public domain).

Strategies for Beginners

Traders with limited or no experience with commodity markets should stick to the most basic strategies for assessing markets.

Beginner Fundamental Analysis

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 crude oil being drilled can offer clues about the direction of markets.

  1. 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.
  2. 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.

Beginner Technical Analysis

Beginning technical analysis traders should familiarize themselves with the following charts:

  1. 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.
  2. Candlestick Charts: These charts show the open, high, low and closing prices for each period being graphed. This data is in the form of bars known as candlesticks. Technical analysis traders analyze the shape of candlesticks to predict future prices.
Candlestick Charts
Candlestick charts are used by technical analysis traders by PIX1861 under Pixabay License.

Strategies for Intermediate Traders

Traders with some experience can begin to incorporate more complex data into their trading strategies.

Intermediate Fundamental Analysis

Intermediate-level fundamental traders may want to delve deeper into the end markets for commodities. For example, strength or weakness in the commercial real estate markets in large cities 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. This 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 Technical Analysis

Intermediate-level technical analysis traders can begin to incorporate more sophisticated charting tools into their trading decisions:

  1. Uptrends: A series of higher highs and higher lows on charts indicates a bullish trading pattern.
  2. 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, crude oil and stocks enjoy a very high price correlation. If one of these markets is making a series of higher highs, then traders might expect the other to follow suit.

Strategies for Advanced Traders

Experienced traders employ the most sophisticated trading strategies.

Advanced Fundamental Analysis

For fundamental traders, these include the following:

  1. 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. Differences in these two values often presage the beginning of long-term bull or bear markets.
  2. Broad Policy Assessment: Actions by central banks can presage movements in commodities prices. For example, a long period of easing by major central banks often leads to higher commodity prices, while a series of rate hikes can produce bear markets.
  3. Major Commodity Analysis: The price action of commodities such as oil and gold often precedes movement in lesser commodities. For example, an uptrend in oil prices might be a good reason to invest in other fossil fuels such as natural gas and heating oil.
  4. Production Output: Traders examine the output of leading producers for clues about big economic cycles. For example, companies might close mines and reduce output when metals prices are low. But 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.
  5. Kondratiev Waves: This technique makes long-term predictions of commodity prices based on economic cycles.

Advanced Technical Analysis

Experienced technical analysis traders also rely on more sophisticated strategies:

  1. 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.
  2. Breakouts: Traders chart resistance and support levels on charts based on historical levels. Breaches of resistance levels generally indicate a move to higher prices, while breaches of support levels often indicate lower prices.
  3. Fibonacci Analysis: Fibonacci analysis predicts retracement levels for commodity prices. These levels are derived from number sequences to predict the resumption of uptrends or downtrends in commodity prices.
  4. 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 isn't always true. The very best traders use 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 signal to buy gold.

FAQs

Below we answer some of the most frequently asked questions.

What are commodities?

Commodities are the raw materials that drive the economy. They are generally divided into soft commodities (agricultural products) and hard commodities (metals and energy). These are the goods that are used as inputs into the manufacture of other goods. For example, wheat is a common agricultural product that is used in the manufacture of flour and breakfast cereal.

Crude oil is probably the most important commodity. It is used to create other commodities like RBOB gasoline and heating oil. But even crude oil itself can be subdivided into Brent Crude and West Texas Intermediate (WTI). Crude oil is usually priced in terms of Brent Crude.

For an introduction to commodities, check out our primer.

How can I trade commodities?

Theoretically, commodities trading is easy: you sign-up with a broker and use their trading platform to buy and sell.

However, before doing so, you need to become are expert at both trading and the commonly traded commodities. You can begin learning about all this in the rest of this article as well as our commodities primer.

Can you make money trading commodities?

Some people make money trading commodities but the vast majority lose money. It is hard work and requires great knowledge. And even then, it is a very risky business.

Trading commodities can be harder than trading on the stock market. For example, commodity futures contracts require you to speculate on prices at a later date. And leveraged trades can cost you far more than you initially speculated.

How much do professional commodities traders make?

Not all commodities traders invest for themselves. They are needed in various parts of the production chain to make sure that commodities make their way to the producers and manufacturers who need them.

According to Glassdoor, the average trader makes $88,000 per year plus $18,000 in additional compensation. But this amount can change dramatically with industry and experience.

According to Houston Chronicle, a trader with more than 5 years experience can make a quarter-million dollars per year — or more. And those working in the banking industry make substantially more than those working for trading firms.

Are commodities high risk?

Commodities trading is very risky. In addition to the normal volatility of markets, commodity prices are affected by various external forces like the weather and the value of the US dollar. Commodities are also traded using leverage normally, which means that you could lose substantially more than you initially speculate. Never trade more than you can afford to lose.

What is the Commodity Futures Trading Commission (CFTC)?

The CFTC is a US governmental agency that regulates futures, options, and other trading derivatives. It is tasked with protecting traders from market manipulation and other abuses. It came into being with the Commodity Futures Trading Commission Act of 1974, which replaced the Commodity Exchange Act of 1936.

What are forward and futures markets?

Futures bind the seller to deliver an agreed-upon amount of a commodity for an agreed-upon price at an agreed-upon date. In exchange for this obligation, the seller receives payment upfront for the commodity. There are two kinds of contracts: forward and standardized (or just “future”).

Forward contracts are traded in the over-the-counter market, which means the contracts are privately negotiated between the two parties. Standardized contracts are traded on an exchange. The Chicago Board of Trade (CBOT) was established for this purpose in 1848. Standardized contracts are also marked-to-market (MTM), meaning their value is determined daily making default less likely.

Comparison of Forward and Futures Contracts

 ForwardFutures
Contract TermsPrivately negotiated between the two partiesStandardized
Method of TradingOver-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 RiskHighVirtually none
Secondary MarketEssentially noneYes. 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?

For 100 years after the start of CBOT, agricultural products were the main commodities traded on futures exchanges. Over the course of the 20th century, other products were added — cotton in the 1940s, livestock in the 1950s, precious metals in the 1960s, and financial products in the 1970s.

In 1981, the Chicago Mercantile Exchange (CME) launched the first cash-settled futures. 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. This allowed trading on prices instead of physical goods.

Once the US Commodities Futures Trading Commission (CFTC) approved the Eurodollar futures contract, exchanges began listing cash-settled futures contracts on other commodities. By the 1980s and 1990s, futures trading expanded to stock market benchmarks such as the S&P 500.

The 21st-century brought online trading. Electronic marketplaces replaced physical trading floors. This change may have had the biggest impact on commodities futures markets since it made commodities trading available to millions of people around the globe.

Traditional Trading Floor
Traditional Trading Floor: NYSE (Pixabay License)

What Are the Top Global Commodities Exchanges?

ExchangeFoundedDescriptionInteresting Fact
Chicago Mercantile Exchange (CME)1898This 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)1848A 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)1882The 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)2000US-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)1877UK-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)1987Australia’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)1984The 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.
Emerging Markets
Emerging Markets by AlexCovarrubias based on the list from the website of Morgan Stanley (public domain).

What are the main drivers of commodity prices?

The supply of and demand for any given commodity are what ultimately drives its price. For example, if new reserves of iron are bound, it will tend to reduce its price.

But a new use of iron would tend to increase its price. Each commodity has unique factors that drive its price. However, certain factors play a role in determining prices for most commodities:

  1. Emerging Market Demand: fast-growing populous countries like India and China are accumulating vast amounts of wealth. They have a growing need for basic goods and raw materials. Demand from these markets has a huge impact on commodity prices.
  2. Inventory levels: major commodity consumers build up inventory levels. Filled and empty storage can indicate where prices will move.
  3. The US Dollar: most commodity prices are set in the US dollar. Things that affect the United States' economy can affect the value of the dollar compared to other currencies can thus affect commodity prices.
  4. Substitution: As prices for a particular commodity climb, buyers will seek cheaper alternatives.
  5. Weather: agriculture is highly dependent on weather but so are energy commodities like heating oil and electricity needed to power air conditioning units.

Important: CFDs are complex instruments and come with a high risk of losing money rapidly due to leverage.

You should consider whether you understand how CFDs work and whether you can afford to take the high risk of losing your money.

Credits: Original article written by Lawrence Pines with contributions from Commodity.com team. Major updates and additions in May 2020 by Frank Moraes.