Trading commodities has been an age-old practice that has evolved over the years. There is a wide range of commodities today and modern-day trading takes place on exchanges such as the Chicago Mercantile Exchange or the London Metal exchange. One requires an account with a trading platform in order to be able to access the commodity markets. Before getting started with commodity trading, here is a guide to commodity trading that covers the basics you need know:
1. What are commodities?
Commodities are essentially materials or resources used to make refined goods. As opposed to goods, commodities are standardised; two units of a commodity in equal measure will be identical regardless of their production or origin, thus also making them interchangeable. A few examples of commodities would be iron, crude oil, natural gas, steel, cotton, silver, grains, pulses, etc.
2. Commodity trading
Commodities have been traded for thousands of years. In the past, they were traded physically. Today, however, commodity trading takes place on exchanges around the world such as the London Metal Exchange (LME) and the Chicago Mercantile Exchange (CME). To trade commodities, you need an account with a trading platform that offers access to the commodity markets.
3.Why trade commodities?
There are a number of advantages to trading commodities. Here are some of the main advantages:
- Leverage can boost gains: when trading commodities it's possible to use ‘leverage' to control a large amount of money with just a small deposit. This is an advantage because it can potentially magnify your gains. On the downside, however, leverage can also increase your losses, so it's important to be aware of the risks. eToro offers leverage of up to x10 (meaning you can trade $1,000 with a deposit of $100) on most commodities and up to x20 on gold.
- Around the clock trading: commodity markets are open for a large part of the week. This means that you can trade on your own schedule.
- Portfolio diversification: commodities tend to have low correlations to traditional asset classes such as stocks and bonds. For example, gold, which is seen as a ‘safe-haven' asset, often rises during periods of economic uncertainty when stocks are falling. This means that commodities can add diversification to a portfolio and potentially help traders and investors lower their overall portfolio risk.
- A hedge against inflation: In the long run, traditional currencies tend to lose their purchasing power due to inflation (the increases in the prices of goods and services over time). Commodities can protect investors against inflation because commodity prices often rise during periods of high inflation.
4. Types of commodities
Investors break down commodities into two categories: hard and soft. Hard commodities require mining or drilling to find. Soft commodities are grown or ranched. There are four main types of commodities.
1. Agricultural products: Soft commodities. They include crops like coffee, corn, wheat, soybeans, cotton, and lumber.
2. Livestock and meat: Soft commodities. They include live cattle, beef, pork bellies, and milk.
3. Energy products: Hard commodities. They include crude oil, natural gas unleaded gasoline, propane, ethanol, and coal.
4. Metals: Hard commodities. They include precious metals, like gold and silver, and industrial metals, like copper, aluminum, and palladium.
5. How to Trade Commodities
There are a few different ways to trade commodities in your portfolio, with their own advantages and disadvantages.
The most common way to trade commodities is to buy and sell contracts on a futures exchange. The way this works is you enter into an agreement with another investor based on the future price of a commodity.
To invest in futures trading, you need to set up an account with a specialty brokerage account that offers these types of trades.
“Traders can access these markets by having an account with a brokerage firm that offers futures and options,” says Craig Turner, senior commodities broker with Daniels Trading in Chicago. You will owe a commodity futures trading commission each time you open or close a position.
Physical Commodity Purchases
When you trade futures contracts, you're not buying or selling the physical commodity itself. Futures traders don't actually take delivery of millions of barrels of oil or herds of live cattle—futures are all about betting on price changes only. However, for precious metals like gold and silver, individual investors can and do take possession of the physical goods themselves, like gold bars, coins or jewelry.
Another option is to buy the stock of a company involved with a commodity. For oil, you could buy the stock of an oil refining or drilling company; for grain, you could buy into a large agriculture business or one that sells seeds.
These sorts of stock investments follow the price of the underlying commodity. If oil prices go up, an oil company should be more profitable so its share price would go up, too.
Commodities ETFs, Mutual Funds and ETNs
There are also mutual funds, exchange traded funds (ETFs) and exchange traded notes (ETNs) that are based on commodities. These funds combine the money from many small investors to build a large portfolio that tries to track the price of a commodity or a basket of commodities—for example, an energy mutual fund based on multiple energy commodities. The fund may buy futures contracts to track the price, or it might invest in the stock of different companies with commodity exposure.
“Commodity ETFs truly democratized the commodities trading game to all investors—they are low cost, readily accessible and highly liquid,” says Giannotto.