What Are Commodities and How Do You Trade Them?

Contents

What Are Commodities and How Do You Trade Them?

Reading Time: 25 minutes

1. Commodities Defined

There are two types of commodities, hard and soft commodities. Hard commodities (also referred to as raw commodities) are mostly mined and consist of natural resources such as oil, natural gas and precious metals. Soft commodities (also referred to as agricultural commodities) are produced or grown products such as grain, coffee and sugar. For convenience, in trading, commodities are sorted into four groups: metals, energy, agriculture and livestock.

Commodity trading is a method to diversify one's portfolio beyond traditional securities. Still, it carries a high degree of uncertainty because commodity prices are susceptible to unpredictable phenomena such as floods, hot weather, wars, interest rates, etc. Some speculators refer to past performance to determine the market price of a commodity by following technical analysis principles whereby they observe historical price action and chart patterns to arrive at trade-worthy conclusions. Others rely on fundamental analysis and investment advice from trained professionals. There is a range of commodities to invest in for both short-term and long-term strategies, as well as financial instruments to choose from in the stock market, futures exchange and other markets.

2. Understanding Commodities Trading

Commodities Trading

Commodities are as ancient as ancient history, for it has existed ever since people needed or wanted something that someone else had. They play such an essential role in our lives that in 2021 the global value of commodities reached a record high of $28.5 trillion (UNCTAD, 2022). Commodities are exchanged across the globe to build our cities, feed our livestock, fuel our cars and make our phones. They have been used to value a nation's currency and provide us with simple pleasures, such as a warm cup of coffee brewed from coffee beans harvested in the valleys of Columbia.

3. Commodities Market Explained

As mentioned, in the world of financial markets, commodities are typically categorised under metals, energy, agriculture and livestock. There are many ways to invest in commodities, including direct investment, commodity futures contracts, commodity ETFs (Exchange Traded Funds), commodity options and commodity CFDs (Contract for Differences).

4. Factors that Move the Prices of Commodities

The extraction, development and transportation of commodities depend on many unpredictable factors. This is one of the main reasons why commodity trading is risky because no matter how much data and market analysis tools we possess, there are just certain things that are entirely out of our control.

Weather – Severe weather conditions can harm agricultural products. Such was the case in 2021 in Sao Paolo, Brazil, whereby the coffee plants of the largest coffee producer in the world were damaged by floods and frost (Araujo, 2022). This led to a worldwide increase in the price of coffee, as demand was high, but supply was low. NASA is also predicting that by 2030, climate change may affect the production of corn and wheat under a scenario of increased greenhouse gas emissions (Gray, 2021).

Economic Sanctions – With the increase in globalisation, economic sanctions imposed on one nation can affect the price of commodities paid by other countries. This can be seen in the war between Ukraine and Russia. To a greater extent, Russia does not have natural gas liquefaction capabilities, forcing them to transport natural gas via pipelines. Most of those pipelines lead towards Europe. The trade restrictions imposed on Russia led to Russia cutting off the gas supply to Europe, which resulted in increased natural gas prices in Europe. Such circumstances create severe economic impacts, but they also inspire countries to strengthen relations and take alternative approaches, leading to the innovation of superior technologies and new trading opportunities (Tian, 2022).

Transportation Costs – An increase in fuel price can increase the price of the commodity being delivered. This is because our transportation system operates on fuel like petrol and diesel. If the price of diesel goes up, so will the cost of transporting goods, which has the ripple effect of making goods sold in our stores more expensive. Higher transportation costs to deliver goods means finding higher prices on our supermarket shelves.

Exchange Rates – The lower the domestic currency value, the more amount of money will be required to buy goods from overseas. This is of particular interest to importing and exporting businesses that depend on the supply of materials from foreign countries to produce their goods. If it is expensive to buy the material from overseas to make a good, then that good will end up being expensive as well.

5. Hard Commodities VS Soft Commodities

Soft commodities are commodities that are grown and cared after. Some examples are coffee, cotton, rice, sugar, livestock etc. They are not as well defined as hard commodities and play a significant role in the futures market. This is because they are susceptible to weather and pathogen uncertainties, which makes it essential for farmers and investors, for instance, to lock in the future price of their crops.

Hard commodities are commodities that are extracted and mined rather than planted and nurtured to maturity. Some examples are oil, natural gas, gold and rubber. They are generally situated in similar geological deposits across the globe, unlike soft commodities that depend more on regional climate conditions.

6. Metals

Metals Trading

Some metal commodities are gold, copper and platinum. Gold is extremely popular and can be found in almost all our electronic devices. Its attractive colour, resistance to tarnish and rarity are some attributes that make it unique. Copper, amongst other places, is used in the building industry and industrial machinery production. Platinum might surprise some as it is used in the glass industry to manipulate molten glass. Metal CFDs can be traded against the Australian or US Dollar as a currency pair with leverage even up to 500:1.

7. Energy

Energies Trading

Examples of energy commodities include natural gas and crude oil. Traders investing in this sector need to be cautious of economic downturns, technological advancements in alternative energy sources and shifts in production enforced by intergovernmental organisations, such as the Organisation of the Petroleum Exporting Countries (OPEC).

8. Agricultural

Agricultural Commodities

Corn, wheat, rice, sugar, cocoa, coffee, cotton and soybeans are all examples of agricultural commodities. These commodities are volatile to severe climate changes and increased transportation costs, which make them attractive to traders because a low supply, in combination with an increase in demand, leads to higher commodity prices and increased potential earnings.

9. Livestock

Livestock commodities

Livestock commodities refer to commodities such as live cattle, pork bellies, lean hogs and feeder cattle. Pathogens like the Highly Pathogenic Avian Influenza (HPAI) in Asia and Europe, increased production costs and market uncertainties across key exporting regions influence the price of livestock commodities worldwide (Upali W., 2021).

10. How to Trade Oil

Oil Trading

Both oil and oil-related assets are traded on the financial markets. A popular choice is Brent Crude and WTI as they serve as oil benchmarks in the global markets. Crude oil is the raw natural form of gasoline, jet fuel and other petroleum products before they are refined for their purpose. It is a non-renewable resource, which means that it can't be naturally replaced at a fast enough rate that we consume it, which makes it a finite resource and attractive to traders.

11. How to Trade Gold

Gold Trading

Gold holds a distinctive position in the world of economics and political systems. It can be traded in its direct physical form or through a gold ETF, futures or mutual fund. It isn't tricky to trade this yellow metal commodity, but it does require a skill set unique to its features. Alternatively, trading gold without knowledge of what affects its value can lead to hidden pitfalls. Before trading gold, it is advisable first to understand the fundamental driving factors that influence its price, such as inflation and deflation, supply and demand.

12. How to Trade Silver

Silver Trading

Like gold, silver is a core commodity used in electronic devices and jewellery. It is also used in the making of mirrors and dental alloys. Popular trading strategies for silver are strategies like trend and range trading. These strategies involve determining a trend through research or determining the price range through technical analysis and then filtering signals based on your findings and adding stop-losses and take-profits.

13. Physical Commodity Trading

Physical commodity trading is about taking raw material from where it is produced and delivering it to an area where it is consumed. So, companies involved in physical commodity trading secure a supply of commodities from the producer and market them across the world to end users or wholesalers. These companies add value to the supply chain because of their unique knowledge of transportation, risk hedging and financing. They deal in huge volumes and often reside in favourable legal environments such as Singapore, the UK and Switzerland.

14. Derivatives Trading

In trade, derivates are a contract between two or more parties that derives its value from an underlying asset like stocks, indices and commodities. The five main types of derivatives in trading are futures, forwards, options, swaps and Contract For Differences (CFDs). In the commodities market, traders use derivatives to fix a price for a particular underlying commodity, to manage their risk and protect themselves from market fluctuations.

To take an example, let's say a car manufacturer calculates that they need five tonnes of steel to build enough cars to supply their customers for the following year. Through derivative trading, the manufacturer will agree with the steel supplier to buy five tonnes of steel at a predetermined date and a fixed price. The reason why a manufacturer may prefer to trade in such a manner, rather than to buy the commodity Over The Counter (OTC), is because the price of steel may rise, which would then make the trade more expensive. For the same reason, it may benefit the supplier to also trade the commodity at a predetermined date and fixed price because the price of aluminium can also drop, which would mean a loss for the supplier. Hence, by trading through derivatives, both the manufacturer and supplier can protect themselves from any detrimental price fluctuations and rely on the fixed price to continue their business endeavours.

15. Using Futures to Trade Commodities

Futures are a financial derivative whereby you enter a contract to buy or sell a particular asset at a specific price and time in the future. Investors can use futures to speculate and hedge on price movements. Futures are usually utilised when trading commodities because it allows commodity traders to limit their risk related to price fluctuations. Some other key advantages of futures trading are access to leverage and portfolio diversification.

16. Risks in Commodities Trading and How to Manage them

The risk in commodity trading is the risk that businesses face when there is a change in the price or availability of a commodity. The risk management companies take in commodity trading involves the steps they take to limit their potential loss and includes strategies like hedging through the use of a futures contract, a forward contract and an options contract.

Four main commodity risks need to be considered when trading commodities. There is a price risk whereby the price may move adversely due to macroeconomic factors. This can also lead to a risk in cost for businesses due to the adverse price movement of a commodity. There is a risk of quantity when a commodity cannot be produced and supplied fast enough to cover demand. Finally, there is also the risk of regulatory changes which prevent businesses or makes it more costly for them to gain access to commodities, like what happens during wars and the cut-off of supply chains.

The approach that businesses take to manage their risk will depend on their organisational structure (whether they are a producer or a buyer of commodities). Some risk management approaches include:

Diversification – Farmers may decide to rotate their crop production to include different products to reduce their exposure to commodity price volatilities.

Price pooling arrangement – This is when businesses collectively sell a commodity to an authorised group, with the purpose of setting an average commodity price based on various market factors.

Futures contract – Commodity buyers and sellers enter a futures contract to purchase or sell a commodity at a fixed price and a predetermined date in the future.

Options contract – These contracts give a company the right, but not the obligation, to buy or sell a commodity at a future date.

17. How to Start Trading Commodities

Trading commodities can be broken down into the following six simple steps:

  • Open a brokerage account

  • Choose your market

  • Decide whether you want to buy or sell a commodity

  • Decide on the size of the trade

  • Manage your risk

  • Keep an eye on your position

  • Know when to exit

Remember, the commodities market is known for its volatility to price fluctuations. So before engaging, make sure to research in depth the commodity that you choose to trade with and understand the various factors that affect its value.

18. How to Choose Commodities to Trade

Choosing a commodity to trade with will depend on individual preferences and areas of expertise. It is preferable to work with a commodity that you understand. The alternative can lead to losses that could have been avoided had the necessary research taken place. Trading commodities is risky because it is volatile to a multitude of uncontrollable factors like severe weather conditions and political agendas. However, with sound research and risk management strategies, a trader can choose a commodity to trade confidently and benefit from commodity price fluctuations with limited risk.

19. How to Choose a Commodities Trading Platform

The right commodities trading platform can make a beginner trader look like a seasoned professional. This is because an advanced trading platform, like FP Markets' MetaTrader 4 (MT4), delivers to traders the necessary tools to make informed decisions and manage their risk effectively. It provides fully customisable charts that allow traders to set up and manage their preferred trading signals that complement their trading style. The right trading platform also offers one-click and automated trading facilities to capitalise on trading opportunities. A few of the main features that you also want to look out for are the tightness of the spread, the speed of trade execution, the restrictions imposed and the level of customer support. Tight spreads, ultra-fast executions and reputable customer service are great indicators of a reliable trading platform.

20. How to Look for A Commodities Trading Broker

Looking for a commodities trading broker is as easy as going to any search engine and simply searching for the term commodities broker. What you need to look out for is whether that trading broker is reputable, is supervised by a financial authority and provides effective research and risk management tools. FP Markets is an internationally awarded broker regulated by strict authorities such as the Australian Securities and Investment Commission (ASIC) and the Cypriot Securities and Exchange Commission (CySEC). They also provide superior trading platforms fully equipped with some of the most sophisticated trading and risk management tools.

References

Araujo, G. (2022, May 19). Brazil's Conab lowers 2022 coffee crop estimate due to bad weather. Retrieved from Nasdaq:
https://www.nasdaq.com/articles/brazils-conab-lowers-2022-coffee-crop-estimate-due-to-bad-weather

Gray, E. (2021, November 2). Global Climate Change Impact on Crops Expected Within 10 Years, NASA Study Finds. Retrieved from NASA Global Climate Change: Vital Signs of the Planet:
https://climate.nasa.gov/news/3124/global-climate-change-impact-on-crops-expected-within-10-years-nasa-study-finds/

Tian, J. S. (2022, August 10). U.S. Department of State. Retrieved from Economic Impact of Sanctions on Russia:
https://www.state.gov/briefings-foreign-press-centers/economic-impact-of-sanctions-on-russia

UNCTAD. (2022, February). Retrieved from United Nations Conference on Trade and Development: https://unctad.org/news/global-trade-hits-record-high-285-trillion-2021-likely-be-subdued-2022

Upali W., G. A. (2021). Meat Market Review: Overview of market and policy developments . Rome: Food and Agriculture Organisation of the United Nations.

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