Commodities Trading Guide

Last Updated July 23rd 2021

8 Min Read

Even though very people realise it, commodities are important aspects of most people’s daily life. The term commodity is used to define any basic good that is interchangeable with other similar goods and is used in commerce. Conventional examples of commodities are goods such as grains, gold, beef, oil, and natural gas.

However, from an investment point of view, commodities offer a valuable means to diversify, especially for those looking to expand their portfolio beyond the traditional securities. As the prices of commodities tend to move in the opposite direction to stocks, certain investors also use commodity trading to see through periods of market volatility.

Earlier, commodities trading needed significant investment of time, money, and expertise, because of which, it was largely limited to professional traders. But today, there are several options available for anyone wishing to participate in the commodity market.

Contents:

Key Points
Commodities Trading – a Brief History
What are the Unique Characteristics of a Commodities Market?
Categories of Commodities
Investing in Commodities through Futures
Investing in Commodities through Stocks
Investing in Commodities using ETFs and Notes
Investing in Commodities through Mutual and Index Funds
Investing in Commodities using Commodity Pools and Managed Futures
Conclusion

Key Points

Commodities can be divided into four broad categories - metal, livestock and meat, energy, and agricultural.
For investors, commodities are a good way to diversify the portfolio beyond traditional securities.
Commodities are risky investment propositions as various kinds of uncertainties impact their market (supply and demand). Most of these are difficult or impossible to predict and include such scenarios as unusual weather patterns, epidemics, and natural and man-made disasters.
Futures contracts, options, and ETFs (Exchange-traded funds) are some of the ways you can invest in commodities.

Commodities Trading – a Brief History

Trading commodities is an ancient profession and was practiced long before people started trading stocks and bonds. The rise of several empires is directly correlated to their ability to conduct effective trades and the facilitation of the exchange of commodities. Even today, people exchange commodities all over the world. The only difference is that it happens through a commodities exchange.

A commodities exchange refers to the physical location where the commodities are traded, and the legal entities formed to enforce the rules for the trading. These rules are set for ensuring standardised commodity contracts and the associated investment products.

Few of the commodities exchanges have gone out of business or have merged. Most of the exchanges carry at least a few different commodities. However, some exchanges specialise in a single category. For instance, the London Metal Exchange only deals with metals and not any other categories of commodities.

What are the Unique Characteristics of a Commodities Market?

All markets are driven by the principles of supply and demand. Commodities markets are no exception to this rule. Shifts in supply affect the demand – generally lower supply means higher prices. As such any severe disruptions in the supply of a particular commodity can lead to higher prices. For instance, if there is a disease that affects the cattle, it can lead to a spike in prices.

Furthermore, global economic development, technological advances and the like will also impact commodity prices. For instance, the rise of China and India as major manufacturing hubs has resulted in lower availability of metals like steel, in other parts of the world.

Categories of Commodities

As mentioned elsewhere, commodities are sorted into four broad categories such as metal, energy, livestock and meat, and agricultural. Let’s now take a detailed look at these.

Metal

Metal commodities include metals such as gold, silver, platinum, and copper. Gold is considered a reliable metal with conveyable value, especially during periods of market volatility or bear markets. Certain investors also invest in precious metals as a hedge to counter periods of high inflation or during currency devaluation.

Energy

Energy commodities consist of items such as crude oil, heating oil, natural gas, and gasoline. The main factors affecting energy products are global economic developments and reduced oil outputs that lead to rising oil prices. Demand for such products has gone up when oil supplies dwindled.

Those who look to enter the energy commodities market should be aware of the impact of economic downturns, shifts in production, new technological advances in alternative energy sources, and more. Alternative energy sources that look to replace crude oil will have a huge impact on the market prices for energy sector commodities.

Livestock and meat

These commodities include lean hogs, pork bellies, live cattle, and feeder cattle. The prices are generally stable, although certain situations (like diseases) affecting cattle health could lead to price fluctuation and volatility.

Agriculture

Agricultural commodities include products such as corn, cocoa, soybeans, coffee, wheat, rice, cotton, and sugar. In the agricultural sector, the prices of grains can be highly volatile during the summer months or periods of weather transitions.

Investing in Commodities through Futures

Futures is one way to invest in commodities. It is a legal agreement to purchase or sell a particular commodity at a predetermined price during a specific time in the future. The buyer of futures takes on the obligation to purchase and accept the commodity when the futures contract expires. The seller, on the other hand, takes on the obligation to supply and deliver the commodity when the contract expires. You can use futures contracts for every category of commodity.

Two types of investors participate in the futures markets for commodities - institutional users and speculative investors. Institutions use futures contracts for budgeting and to normalise expenses and reduce cash-flow worries. They use futures to reduce risks due to price fluctuations.

Airline companies engage in hedging with futures contracts which allow them to buy fuel at fixed rates for a specific period. This allows them to override the volatility in crude oil and gasoline prices.

Speculative investors are those who purchase assets for short period and use certain strategies to profit from the price changes. They hope to profit from price changes in the futures contract. As they don’t deal in actual goods, they close their positions before the contract is due.

The analysis is easier in futures contracts as it is based on the basic commodity. There is huge potential for profits, and it is easy to take long or short positions in the future.

However, as the markets can turn volatile, direct investment in commodity futures contracts is highly risky for inexperienced investors. Although there is potential for a huge profit, there is an equally high chance of loss too. If the trade goes against you, you will lose your initial deposit and more before you can close your position.

Still, you can use the futures options as a low-risk way to enter the futures markets. It is like putting a deposit on purchasing something instead of buying it outright. With the futures option, you have the right–but not the obligation–to follow through on the transaction as the contract expires. Hence, if the price of the futures contract moves contrary to the direction you anticipated, you can limit your loss to the cost of the option you bought.

Check Out: 7 Easy Ways To Start Investing With Little Money

Investing in Commodities through Stocks

Investors interested in entering the market for a particular commodity can invest in stocks of companies related to a commodity. For instance, if you are interested in the oil industry, you can invest in stocks of refineries, tanker companies, or oil drilling companies. Those interested in gold can buy stocks of mining companies, smelters, refineries, or other firms dealing with gold.

Advantages of stocks are that they are less prone to volatile price swings, easier to hold, trade and track, possible to narrow down the investments, and so on. However, you need to choose the company well. It is easier to invest in stocks as you are more likely to hold a brokerage account already. However, you should bear in mind that stocks are never a pure-play on commodity prices and the prices might be influenced by company-related factors unrelated to the commodity traded

You can also buy options on stocks. Like options on futures contracts, options on stocks need lesser investment than buying stocks. It means that you will minimize the risk when investing in a stock option.

Investing in Commodities using ETFs and Notes

Exchange-traded funds (ETFs) and exchange-traded notes (ETNs) are also good options for investors wishing to enter the commodities market. Both trade like stocks and let investors profit from fluctuations in commodity prices without having to invest directly in futures contracts.

Commodity ETFs track the price of a particular commodity–or group of commodities by using futures contracts. Both ETFs and ETNs allow investors to participate in the price fluctuation of a commodity or basket of commodities, without needing a special brokerage account. There are also charges or fees with ETFs and ETNs as they trade like stocks. However, not all commodities have ETFs or ETNs associated with them.

Investing in Commodities through Mutual and Index Funds

You can’t use mutual funds to invest directly in commodities. But, you can use mutual funds to invest in stocks of companies involved in commodity-related industries. However, there are a small number of commodity index mutual funds that allow investment in futures contracts and commodity-linked derivative investments.

Investing in mutual funds offers you the benefit of professional money management, better diversification, and liquidity. However, the management fees are sometimes high, and few funds might carry sale charges.

Investing in Commodities using Commodity Pools and Managed Futures

A commodity pool operator (CPO) is someone who gathers money from investors and pools it to invest in futures contracts and options. CPOs share periodic account statements and annual financial reports. CTAs must be registered with the Commodity Futures Trading Commission (CFTC) and they usually have a commodity trading advisor (CTA) to advise them on trading decisions.

Participating in CPO offers you the advantage of professional advice from a qualified CTA. Also, the pooled structure means the manager has more money and more investment opportunities.

Conclusion

There are several ways to get into commodities trading. The tools and strategies vary according to your expertise and experience. Whether you are a novice or an experienced trader, you’ll have access to a wider variety of options for investing in financial instruments offering access to the commodity markets. Although commodity futures contracts offer the most direct way to partake in the price movements, there are several additional types of less risky investments with sufficient opportunities for commodities exposure.

However, you should remember that by nature, commodities are considered risky investment propositions as they can be affected by uncertainties that are difficult, if not impossible, to predict. Uncontrollable and unpredictable events such as strange weather patterns, epidemics, and natural or man-made disasters, all can have an impact on your commodity trading prospects.