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What is commodity trading? Discover how to trade in 2019

What are commodities?

If you are new to trading on the financial markets, then one of your questions will be: what is commodity trading? A commodity is a good that is used in commerce. These include energy products such as oil and natural gas, precious metals and agricultural products. You can speculate on rises and falls in commodity prices without having to buy the commodity, but the market can be risky.

  • Commodities are goods
  • Include energy and agriculture products
  • Can be traded by individuals
  • Potential high risks when trading in volatile markets
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The basics about commodities trading

Once you are clear about what commodities are you can start to plan on how to trade them. Bear in mind that the traditional way of describing commodities relate to tangible goods that include agricultural products, such as wheat, rice, beef and barley, energy products that include natural gas and oil, and precious metals such as gold, silver and platinum. The definition of commodities has expanded more recently and can now include financial products, such as indices and foreign exchange, the latter more commonly known as Forex. Newer types of commodities have also emerged, including bandwidth and mobile phone minutes.

Commodities are traded on exchanges and usually are carried out by way of futures contracts. The exchanges standardise the quantity of the commodity to be traded as well as its minimum quality. As an example, an exchange might state that a specific grain contract is for 5,000 bushels and it will also specify the grades of grain that can be used for the contract to be satisfied.

When you trade commodities, you will be doing your trading on structured exchanges where buyers and sellers in relatively small numbers will meet to agree prices. Anyone involved in commodities trading will be speculating on the future price of the particular good – be it gold, cotton oil or any other relevant commodity – and making judgements on whether prices will go up or down. You can use spread betting or Contracts for Difference (CFDs) for your trading strategies.

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Commodity trading explanation – how it works

Whichever method of trading you decide to use, whether using commodity CFDs or spread betting, you will be trading by using a leveraged-based derivative product. With derivatives you can trade on the commodity’s price without having to take delivery of that commodity at any time. As you will not own the commodity you can trade from anywhere if you have access to a computer or a phone. Most brokerage firms have mobile apps that can be downloaded for tablets and smart phones using either Android or iOS software.

Leverage refers to the way you can get bigger returns when you speculate in the commodities markets by using borrowed capital. It means that you do not have to put a large amount of capital up front and is a powerful tool that can enable you to control large market positions with a relatively small initial investment. As with any investment, there are positives and negatives to using leverage. You could make enormous profits, but you could also lose significant sums if things do not turn out the way you had planned.

Leverage is also known as margin and is used both for commodities and stocks. If you decide to trade on margin with commodities there is a lower requirement for margins than there is for trading stocks. The potential for losses or profits is therefore much greater when trading commodities this way than if you were investing and speculating in stocks.

cfd 2

Buyers and sellers of commodities

As previously stated, the buying and selling of commodities are normally carried out by using futures contracts. These contracts are legal agreements where you agree to buy or sell a specific commodity or an asset at a price that is predetermined. The buying or selling must be at a specified future time. Futures contracts are traded on a futures exchange, a central marketplace that is now mainly done electronically. The quality and quantity of these contracts are standardised to make trading easier on the exchange.

Trading commodity futures attracts two types of traders, the buyers and producers of commodities and the speculators.

The buyers and producers use commodity futures contracts so they can hedge against the risk of losing money. This was the original intention for these types of contracts. If, for example, a farmer planted a crop of barley, a futures contract can be sold on planting the crop so a predetermined price is guaranteed for when the barley is harvested. The trader, once the futures contract has expired, will make or take delivery of the commodity.

Speculators never take delivery of a commodity and never intend to. Their sole purpose is to make a profit out of volatile price movements in the commodities markets once the futures contract has expired. Specialist intraday traders, those who open and close a trading position in the course of one day, often trade in futures markets as they are very liquid and frequently have high volatility.

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How to trade commodities futures – 1

Before you start to trade commodities you should do as much research as you can into the risks and rewards of this type of trading. You can easily find a commodity trading guide, some of which have a more detailed commodity trading explanation than others, but the main thing is to familiarise yourself with professional information.

When you do decide to invest in a futures contract you will need to open a brokerage account with a broker that allows you to trade futures. You will find a wide range of online brokerage firms and it is worth taking some time to do a broker comparison to see what tools and support they offer for trading and what their terms and conditions are, especially in relation to fees and costs. Not all brokers offer the same trading platforms, but the MetaTrader4 platform is very popular, particularly for investors who are just starting out in the trading world.

On signing with a broker, you will need to fill in a form to show that you understand the risks involved in futures trading, so again make sure your preliminary research gives you enough background and knowledge for you to be able to make that risk assessment confidently.

After your account has been set up you will have to put down a minimum deposit for each commodity contract, and amounts differ depending on which broker you use. The value of the account will increase or decrease depending on the contract’s value.

How to trade commodities futures – 2

If the value of your contract decreases you will be liable for a margin call because the value of the account has fallen below what the broker requires for minimum value. You can either put some more money into your account or, if you have them, sell some of the assets that the account is holding. Working out margins can be complicated but your initial research should give you the information you need. By continuing to fund the account you will keep your trading position open.

Bear in mind that there can be large returns or losses with only small price movements as there are large amounts of leverage, so you could double your money in just a few minutes or, over the same time period, lose it.

As with any type of trading there are advantages and disadvantages in futures. On the positive side you are trading on the underlying commodity and by using leverage you could make large profits provided you were on the right side of the trade. Having a minimum deposit account allows you to control full-size contracts that you may not otherwise have been able to afford. You can also easily take a long position, where you expect the commodity to increase in value, or a short position where you expect the value to decrease.

Disadvantages include the market’s volatility, making it high risk, with the potential of losing your deposit before you can close your position.

etf 2

Trading commodities using stocks

If you are looking at other ways of trading commodities either instead of or to complement your trading in futures, there are many traders that use stocks of businesses that are in some way related to commodities. If you are interested, for example, in oil you could invest in companies involved in drilling, refining or tankers as well as in oil companies that have diversified. If gold or silver is what interests you in terms of investing you could look at buying stocks in mining companies, refineries or smelters to diversify your trading portfolio.

Equities are generally reckoned to be less at risk of volatile price swings than is the case with futures. Buying stocks in companies is easy and it is equally straightforward to hold, trade and track their performance. You can narrow your investments to a particular sector, but you need to do your homework and make sure a company you plan to invest in has a sound track record and that the commodity has also generally performed well on the markets in the past.

You can buy stocks directly or go for stock options that need a smaller investment if you are light on capital. With these the risk is limited to the option’s cost.

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Exchange Traded Funds (ETFs) and Exchange Traded Notes (ETNs)

You can use these methods to take part in price fluctuations of commodities and you do not have to invest directly in futures contracts. A commodity ETF will usually track a particular commodity’s price but may also track the price of a group of commodities. These consist of an index and use futures contracts, though you can back an ETF where the commodity is held in storage. A famous example is when a US university’s investment management company placed a percentage of its portfolio (quite a small percentage) in actual gold bullion bars that were kept in a bank vault!

ETNs are an unsecured debt that is designed to imitate a specific commodity’s price fluctuation or that of a commodity index. ETNs are backed by the organisation that issues them and if you choose to invest in either commodity trading method you do not need to have a special brokerage account. You should always research the markets before you invest.

With either type of investment you will not have to pay management or redemption fees as they are traded like stocks and they give you an easy way to take part in a commodity’s price fluctuation. However not all commodities are associated with an ETF or ETN and there is a credit risk with ETNs associated with the issuer.

Conclusion:

Conclusion

In general terms trading commodities can be a good way to invest because you can easily see the way prices move on the markets. What will make the difference in turning a profit or making a loss on commodities trading is your level of understanding of how the markets work and a developed level of experience, so you are comfortable with taking positions and closing them when you want to.

There are always risks associated with investing, which is why many people choose to have professionals taking care of their investments, but with the right knowledge you can aim to make a success of your trading. It is a good idea to practice with a demo account at the broker you choose until you feel ready to “go live”, and most brokers offer you that option as well as plenty of educational help to give you a deeper understanding of how to invest.

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