Commodity Trading: What Do Commodity Traders Do?
Reading Time: 10 Minutes
What is a Commodity Trader?
A commodity trader’s primary objective is to generate a return through buying and selling commodities, typically through a brokerage firm. Commodities range from crude oil and natural gas (energy commodities that power the global economy) to gold and silver (precious metals that hold value over time), and agricultural commodities such as wheat and cocoa (the foundation of the food industry which powers the worldwide population). Commodities are recognised as fungible and liquid trading assets (fungible means one is as good as another—interchangeable).
The prices of commodities fluctuate constantly due to supply and demand changes. A commodity trader, a short-term speculator, aims to produce a profit by correctly predicting these price fluctuations: this means buying or selling at the right time.
Where are Commodities Traded?
There are several avenues in which commodities can be traded beyond the physical exchange of goods. One of the most common forms of trading commodities is through futures contracts at a futures exchange. Through the futures market, legal contracts are formed on an exchange between market participants to buy/sell an underlying commodity at a predetermined price in the future. Like forward markets, the futures markets work with underlying assets which fall under two groups: commodity underliers (physical goods such as gold or coal) or financial underliers (securities such as shares or bonds). Interestingly, a large majority of futures contracts are cash settled, meaning physical delivery in the futures market is rare. Another popular derivatives market for trading commodities is the CFD market (Contract for Difference).
Other forms of investment vehicles range from commodity-related stocks in the equity market; these could be mining as well as oil producing companies, for example. ETFs, or exchange-traded funds, are another investment vehicle that can be used to track (follow) a specific basket of commodities. A popular ETF in the commodity space is the SPDR Gold Shares ETF, which tracks the price movements of gold and is also offered as a CFD product with FP Markets. See here for more details on the different ETFs offered at FP Markets.
Note that unlike the SPDR Gold Shares ETF, commodity ETFs seldom own the physical commodities the ETF is based on. It is usually formed on the back of derivatives, futures contracts backed by the commodity.
Understanding Commodity Traders
As with other financial markets, such as stock trading, bond trading, currency trading and even cryptocurrency trading, commodity traders differ in terms of their objectives, trading styles and trading strategies.
Two prominent examples of commodity trading:
- Speculative traders in the commodity space tend to work with shorter-term timeframes. Day traders and scalpers, two well-known short-term trading styles, often liquidate positions ahead of the day’s close. Commodity markets also have a reputation for volatile trading conditions. Take XAU/USD (spot gold), for example, the precious metal, at the time of writing, is 7.5% higher, month to date. Between September and early November 2022, the ATR (Average True Range: a popular volatility measure among technical analysts) increased from $19.91 to $29.90. That is a daily trading range of nearly 30.00 USD. Other trading styles to be aware of are swing trading and position trading which focuses on longer-term investment horizons.
- Large companies also often engage in the commodity markets in search of price guarantees. Imagine Airline company XYZ believes the price of oil will continue to rise in the future, the company’s financial division may consequently decide to mitigate this price risk through the futures market. With the airline company displaying a future need for oil, the company can hedge to buy: buy a futures contract to guarantee a specific price for oil in the future. If the price of oil rises, as expected (which means it’d be more expensive to purchase for the airline void of a futures position), the company can liquidate its current futures contract (profiting from the price rise to fund the difference between the futures and spot price) and purchase oil on the spot market at the current price.
The Disadvantages of Commodity Trading
While there are several advantages in the commodity space, including diversification to minimise risks in a portfolio (reduce portfolio volatility), hedging against inflation and, dependent on the market traded, liquidity and leverage facilities, there are also downsides.
As with all forms of investment, downsides (risks) are present with commodity trading. This ranges from liquidity risks to market risk. Commodities can be a volatile space to trade, particularly for newer traders. Learning how to accommodate this risk (volatility) in a commodity trading strategy is, therefore, recommended. The same can be said for leverage. While leverage may be an advantage for an experienced trader, leverage could prove detrimental for new traders and may lead to account ruin if not respected.
How Do I Start Commodity Trading?
Commodity trading is available through various brokers. FP Markets offers a broad range of commodity CFDs, a financial contract that allows investors to speculate on the price of commodities without owning the underlying asset. CFD commodities are available for both hard and soft commodities on Metatrader 4 (MT4) and Metatrader 5 (MT5) platforms. A CFD essentially pays the difference between the opening and closing price of a position, and are also leveraged products that allow traders and investors to trade both long and short positions.