The global economy runs on raw materials such as precious metals, livestock, fossil fuels, and iron ore. These raw materials are the commodities used to produce finished goods. Typically, commodities can be a natural resource of any kind consumed by individuals and industries.
Commodities offer unique opportunities for trading through their constantly changing prices. For a sophisticated investor, making good profits from commodities is easy.
If anything, commodities are an excellent opportunity for diversification, but it is not without shortcomings.
Commodities carry more risks than other investment vehicles, and you need specialized knowledge to succeed in it. So what are they all about? The following guide may come in handy for those willing to learn about trading in commodities.
Trading Commodities: What they are
Securities such as bonds and stocks are not physical goods that you can see. They exist as financial contracts. In contrast, commodities are traded in their physical form.
Commodities can be in the form of precious metals such as palladium, silver, gold, platinum, or industrial metals such as zinc, aluminum, copper, and iron ore. They can also be energy such as ethanol, natural gas, oil, or even renewables such as solar power and wind power.
Edible and non-edible agricultural goods and livestock are also trading commodities.
The prices of commodities are not constant. They depend on demand and supply forces. A change in the production of oil in the Gulf can affect global prices of oil.
The primary objective of investing in the commodity market is to profit from the supply and demand changes, and it is important to learn how to navigate the commodities market.
Commodities are a different asset class and an opportunity to reduce risk in the portfolio through diversification. They provide differentiated exposure from other investment markets and have the potential to cushion against a dismal stock market performance.
Commodity Trading
The essence of commodity trading is exchanging different physical commodity-based assets or futures contracts. Investors make bets based on the trading of futures contracts and the anticipated value of a particular commodity in the future.
For example, if the investors expect the price of grains to go up following a depressed harvest, they buy the associated futures. Investors go short or sell the futures off if they anticipate the price decline.
Commodity trading is not a new concept. It started long before the evolution of modern investment markets and can directly be linked to the rise of many empires in history.
In the US, commodity trading started with the Chicago Board of Trade in 1848. It allowed farmers to fix the prices even at certain times when the harvests are in surplus. They could use futures contracts to agree to the price of agricultural produce to cushion against price changes.
Unlike in the past, the current commodities market is well developed, and there are various commodities exchanges around the world.
A commodity exchange is a legal entity for trading in commodities and for enforcing related rules. The United States has several commodities exchanges, and they include the Chicago Mercantile Exchange (CME), Kansas City Board of Trade, Intercontinental Exchange (ICE), and New York Mercantile Exchange (NYMEX).
The list of varied commodities is now extended, and you can trade anywhere at any time.
How You Go About Trading in Commodities
There are various ways of trading commodities. Each of these has its advantages and disadvantages.
i) Futures
Futures exchange is the most common way to trade commodities. Classically, one investor agrees with another based on the anticipated price of a particular item.
For example, you can agree to a future contract to purchase 1000 lbs of grains at $10 per pound in 30 days. There is no transfer of physical goods at the end of the agreement, but you close it out by taking a different position through spot trading.
You profit when the contract price ends up higher than the spot price, and gain when the spot price falls if you had entered a contract to sell. Usually, you don’t have to wait for the expiration of the agreement. You can close it out at any time.
Investors in the futures market can either be speculative investors or users of the commodities. Service providers and manufacturers use futures to have a consistent figure of expenses and reduce challenges associated with the constantly changing prices. Participation of the service providers and the manufacturers is meant to minimize possibilities of financial loss from the change in the price of commodities.
A good example is the airline industry. Airlines hedge with futures contracts to secure considerable amounts of fuel, and the industry escapes crude oil and gasoline volatility in the market. Without hedging from the futures contracts, the industry can very quickly collapse.
On the other hand, speculative investors use sophisticated strategies and hold assets for short periods to profit from the changing prices. Because they do not rely on the commodities they are speculating on, the investors close their positions before the due date of the futures contract. That means the investors will never actually take possession of the commodities.
You need an account with a brokerage firm to trade in futures. As an aspiring investor, you will be required to fill out a form stating that you understand the risks associated with futures trading. Depending on the broker, you may need to maintain a minimum deposit. You pay a trading commission every time you open or close a position.
ii) Commodities Stocks
Another common strategy of trading in commodities is buying stocks of companies that deal with particular commodities. For example, you can purchase the stock of a gold mining company or a large agricultural company.
Typically, the prices of stocks vary based on the cost of the associated commodity. If the prices of grains go up, the stocks from the grain company go up, and the investor gains. It is less risky to invest in commodities stocks than futures.
But a well-run firm would not be affected by the commodities price drop, and there would be little or no effect on the stocks. Commodity stocks are not the best where the investor looks to benefit from the constant price variations.
iii) Physical Commodities
The futures market involves betting on changing prices. There is no actual transfer of physical commodities such as sacks of coffee beans. But for precious metals such as silver or gold, you can take possession of tangible commodities.
These investments have an actual weight that you can feel and gain exposure to. But the shortcoming of precious metals is in their higher transaction costs.
- Metals such as copper, platinum, silver, and gold sometimes serve as a hedge against currency devaluation or in periods of market volatility. Gold is mainly used based on its conveyable value, dependability, and reliability.
- Agricultural commodities markets of rice, coffee, soybeans can become very volatile in periods of weather transitions. Opportunities for gains in the market arise when there is population growth and a limited supply of agricultural produce.
- The energy sector commodities are a bit complicated to navigate, especially at the moment. Factors such as technological advances in renewable energy sources, production controls by the Organization of the Petroleum Exporting Countries (OPEC), and economic downturns can affect the energy commodities market.
- A good strategy for investment in physical commodities is to deal with value-dense items such as platinum and gold. But even with these, there are higher markups above the spot price in most cases.
iv) Commodity Mutual Funds, ETFs and ETNs
These investment tools pool funds from investors to create an extensive portfolio that tracks a basket of commodity prices. The fund may invest in commodities futures to track their prices or stock of different commodity companies with sufficient exposure.
The most accessible is Commodity ETFs. They are highly liquid and low-cost for anybody to invest in them. You only need a small investment to be a stakeholder to a broader range of commodities, and you have a professional managing it for you.
The price for the service is a management fee. In some cases, the fund may not be quite effective in tracking the price of the commodity. But it mostly depends on the approach.
v) Managed Futures
Private funds are similar to mutual funds, but they are not publicly traded. As such, you need to request and be approved to invest in private funds.
Another difference between ETFs and mutual funds is that managed futures can employ complicated trading strategies. They, therefore, have a higher potential for higher returns. However, the management costs of these private funds are on the higher side.
Final Word
Investing in the financial markets is now easier for any level of investor, including a beginner. You can use various investment vehicles to grow your wealth, but make it your primary goal to diversify. Typically, commodities futures contracts add a bit of variety to your investment portfolio and improve your earning potential. The futures behave differently from other investment markets such as stock.
However, you should be cautious when trading in commodities. This is because they are affected by changing weather and the global supply of natural resources. Understand the commodity price charts and other important information to make informed decisions.
