Trading commodities

Author: Martin Moni
Martin Moni
All publications of the author

The trading of commodities has been around since the beginning of civilization, primarily involving the exchange of physical commodities. Nowadays, this type of exchange is still available and many manufacturers still participate in the physical trade of commodities, but a new breed of trader has got into the game – the speculator. A speculator is not interested in wheat, oil or coffee, but is out to make a profit from the price changes of these commodities. As a Forex trader, you should be aware of this market in order to help you hedge your trades and make more money.

Unlike those previous decades, commodities trading now happens through centralized exchanges, and some of the biggest ones in the world include:

  • New York Mercantile Exchange (NYME)
  • Chicago Mercantile Exchange (CME)
  • London Metals Exchange (LME)
  • Intercontinental Exchange (ICE)
  • Tokyo Commodity Exchange (TOCOM)

Each of the above exchanges has one or two specialties, and none allows the trading of all types of commodities. For this reason, a trader interested in a particular commodity has to identify the exchange that allows for trading of that commodity. Luckily, we no longer need to travel to the exchange physically, and with the right broker connected to the exchange, anyone can participate in the commodity market. This is why you should be careful when choosing a Forex broker, and find out if they can offer you all avenues for trading.

What is involved in the commodities market?

There are 3 main categories of commodities traded:

Energy

These are materials used for the generation of energy and the main one is, of course, oil, which is used for many functions from transport, tarmacking, cosmetic products to creating plastic. The 2 main forms of crude oil are Brent and West Texas Intermediate (WTI) whereby the former is considered ‘sour’ and the latter ‘sweet’. Brent crude oil used to be less expensive because it required more processing compared to WTI, but an oversupply of WTI from the US has caused Brent to become more expensive, although only by a few dollars. In spite of this, the prices of both these crude oil types are still highly correlated and you rarely find the price shifts moving in opposite directions.

Besides oil, the remaining energy commodities aren’t very highly traded such as natural gas, heating oil and gas. Nevertheless, a trader should never ignore any commodity as it may present a trading opportunity at the right time.

Metals

Also referred to as ‘hard’ commodities because of their solid nature, these are mostly precious metals and also those used by manufacturers for making products. The precious metals include gold, silver platinum and palladium while industrial metals include aluminium, copper, lead and many others. In this category, gold plays the main role because it is considered a primary commodity that can be used in exchange for fiat money, which explains the rising price of gold in periods of economic uncertainty like just before the Brexit vote.

Agricultural products

These are also called the ‘softs’, and include both livestock and produce. Examples of such softs include wheat, soybeans, coffee, cocoa, sugar, rubber and even live cattle.

How to trade commodities

There are several ways a trader can get in on the commodity market, all of which make use of all the above commodities:

Direct trades

Just like when trading the futures market, it is also possible to buy or sell physical commodities and never having to actually handle the item physically; although you could. This is the simplest way to trade commodities, and most brokers will offer you the option to do this. In the past, it was difficult for an individual to trade commodities directly because only very high quantities and monies were required, but these days anyone can participate.

Among the list we have of brokers according to Forex broker independent rating, the highest rated brokers will allow you to trade commodities as a speculator. The great thing about using such a broker is that they will also provide you with a high leverage, similar to that of Forex, allowing you to trade high quantities of commodities.

Contracts for difference (CFDs)

Finally, the easiest and simplest way of trading commodities is trading them through their CFDs like futures and options. These, too, are traded through an exchange, and you can quickly compare CFD brokers to find if they offer a CFD for your preferred commodity. Fortunately, nearly all commodities will have a CFD for it, which is what manufacturers use to ensure they get the desired price for commodities.

There are also binary options for commodities, and our Top Rated Binary options brokers rating page can guide you to identifying the best broker for that purpose.

Exchange traded funds (ETFs)

Despite being able to trade commodities directly, you still require a huge amount of capital to trade them. This is because commodities are traded in certain quantities – oil in barrels, wheat in bushels, gold in ounces, etc. Considering that an ounce of gold right now is about $1,165, a regular trader might not be able to purchase enough of the commodity to make enough profit. This is where ETFs come in.

An ETF acts like a stock, which means you can buy a smaller piece that the entire minimum quantity. ETFs are created by authorized participants (APs) who are investors with a lot of capital, usually a bank. They buy a huge amount of a commodity and hand it over to an exchange where it can be traded by an individual trader – just the same way a company gets listed on an exchange. Now, any trader can be able to buy or sell an ETF based on the underlying commodity.

ETFs have become very common because they allow traders, regardless of their capital to participate in the commodities market, but there’s a problem. Not all commodities have ETFs, which means that you may not find an ETF for the particular commodity you were interested in. The most common ETFs are those of oil, gold, natural gas and other common commodities; it may be difficult to find an ETF for, say, cattle.

However, you should be careful about ETFs, and enquire whether the ETF is tracking the commodity itself or a derivative. Some ETFs may be created based on futures of a commodity, tracking that futures contract instead of the commodity itself, which reduces the amount of profit to be made from the price changes.

Index funds

We have already mentioned that commodities are traded through an exchange, from where traders can buy or sell a particular commodity. Just like the NYSE, too, these commodities exchanges also have an index, which combines the value of all commodities in the exchange into a single ‘basket’ tracking the performance of the underlying commodities. Trading an index fund is the same as buying or selling all the commodities combined, which means you can make a huge profit when there’s a boom in the prices of the commodities since these exchanges deal with similar commodities.

As an example, the London Metals Exchange (LME) primarily deals with industrial and precious metals, so if you happened to short the LME index (LMEX) during a time of economic crisis, you would benefit from the combined dip in commodity prices. Below is an image of some commodities in the LME during the Greek debt crisis and the slowing growth of China in June 2015. Instead of shorting each commodity, a trader could short the LMEX and profit from the combined price dip of all metals at that time.

How to use your knowledge of commodities

Now that you know the basics of commodity trading, you could use that information to participate in the commodity market in the above ways. However, you can use this information to compliment your other trades. For example, now that you know about certain commodities, you can use information about that commodity to inform your trades in the stock and Forex markets.

Say, you find out as you’re checking up on the various hard commodities, you find that oil prices have been falling for the past week. Your knowledge of commodities will let you know about the countries which are most dependent on oil exports like Canada, Norway, Russia, etc. and you can sell their currency against an oil importer. Alternatively, for a stocks trader, price fluctuations for a commodity like wheat can affect how you trade the MacDonald’s stock, whereby the recent drought in California affected crop production.

Basically, this article does not simply encourage you to trade commodities, but rather inform you of a new trading avenue.

Risks in commodity trading

All forms of trading carry risk, and you should already know this by now, but commodities have a high intermittent volatility. For example, the price of coffee can remain relatively stable for months and then rise sharply within a week. The reason behind this is that commodities, unlike other financial instruments, are subject to unpredictable events like weather, accidents and natural disasters.

Looking at the image below, you can see that the price of coffee rose by 69% within a year upon fears that drought in Brazil, the largest producer of coffee worldwide, was going to lower the amount of coffee produced. Drought, just like other weather conditions is pretty unpredictable, which makes commodity trading a lot riskier than other securities. Another risk may include factors like politics affecting a particular country, the delivery and storage of the commodity.

Due to this risk, commodity trading should be approached with a lot of caution, and it is not recommended for novice traders. It requires that you be up to date with news announcements from all over the world to know about any important topics – the actual economic calendar Forex won’t be enough. The commodity market is great for hedging, though, and you can allocate a small percentage of your portfolio to commodities to cover any losses you incur on your other trades.

 

For a look into how commodities exchanges work, here’s a quick video:

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