If you're interested in commodity trading, the good news is that it's never been easier to get started. But before you do, it's essential that you have a solid understanding of the fundamentals. In this guide, we're going to take a look at:
- The history of commodity trading
- What is a ‘commodity'?
- Where are they traded?
- The 6 best ways to trade them
- Tips and strategies to maximise profits
History of Commodities Trading
Markets for the exchange of commodities are as old as mankind. Whether you travel back to written tokens in Sumerian clay jars, or to records of rice transactions in Asia some 6,000 years ago, the need to reward both producers and users of commodities, independent of market price risk, has always been present.
What was needed was a fungible and tradable contract that fixed a future price, and then allowed traders/speculators to deal with the risk components of the transaction.
The origin of these ’futures contracts’ is said to be in the early 1800s in the United States for the wheat trade. By 1848, the Chicago Board of Trade (CBOT) was formed, which standardized these contracts and became the counterparty for the risk, thereby enabling trading of these contracts to take place.
Fast forward to the present day, and there are now roughly 50 of these commodity exchanges spread across the globe that facilitate the trading of futures contracts and options for a long list commodities.
Commodity Trading Basics
In this section, we will take a look at the fundamentals of commodity trading including:
- What a commodity is
- Where they are traded
- Commodity regulation
What Is a Commodity?
A commodity is a raw material that can be grown, extracted or mined for use in the production process to manufacture finished goods. We impact the commodities market with our actions every single day. From the moment we sip a cup of coffee in the morning to the clothes we choose to wear, the car we drive and the groceries we buy.
Commodities are the building blocks of nearly everything we use in life, whether they are mined from beneath the earth’s surface or grown on the topsoil of the planet. Commodity trading has evolved over time to smooth out the financial bumps in the road from the producer/miner to the user/manufacturer, both of whom must make substantial capital commitments before fixing market prices.
Where Are Commodities Traded?
Commodities are traded on an exchange through futures contracts, stocks, and ETFs, while they can also be bought and sold in their physical states. The largest commodity exchanges in the world are:
- CME Group
- Tokyo Commodity Exchange
- Euronext
- Dalian Commodity Exchange China
- Multi Commodity Exchange
- Intercontinental Exchange
- Africa Mercantile Exchange
- Uzbek Commodity Exchange
Some exchanges specialize in a particular group of commodities, including:
- Chicago Mercantile Exchange (energy and metals)
- ICE Futures US (agricultural products)
- Chicago Board of Trade (agricultural products)
- LIFFE (agricultural products)
- London Metal Exchange (non-precious metals)
- ICE Futures Exchange (energy)
What Is a Commodity Exchange?
A commodity exchange is an exchange, or market, where various commodities are traded. Trading on an exchange includes various types of derivatives and contracts based on these commodities, such as forwards, futures and options, as well as spot trades. Access to these exchanges can be direct or through brokers – the obvious path for individual traders.
Are Commodities Regulated?
Each commodity market has a primary regulator, much the same way as with regulatory oversight of stocks. In the United States, the primary regulatory body is the Commodity Futures Trading Commission (CFTC), while the Financial Conduct Authority (FCA) performs the same function in the UK. Other well-known regulatory bodies from around the world include ASIC (Australia), BaFIN (Germany), FMA (New Zealand), FINMA (Switzerland) and FSA (Japan).
Types of Commodities
So far, you’ve had an overview of the commodities market. Now, it’s time to take a look at:
- The main type of commodities
- The difference between hard and soft commodities
- What is the most valuable commodity
- The most traded commodities in the world
- Commodity risk factors
There are no hard and fast rules for categorizing commodities. The classifications are general, each comprising a multitude of items. An EFT may include a group classification, but a trade in the futures market could be for a specific commodity or index, i.e., for a specific commodity or basket of commodities.
As with foreign currencies, there are primary commodities, which have large turnover and liquidity, and secondary ones, with smaller volume, less liquidity, and higher risk.
What Are the Major Commodities?
Tradable commodities fall into a number of categories including grains, softs, livestock, energy, metals and ‘other’.
- Softs (cocoa, coffee, cotton, orange juice, sugar)
- Livestock (feeder cattle, live cattle, lean hogs, pork bellies)
- Energy (brent crude oil, WTI crude oil, gasoline, heating oil, natural gas)
- Metals (steel, copper, iron, gold, nickel, palladium, platinum, silver, aluminum)
- Other (lumber, rubber, wool)
What Are Hard and Soft Commodities?
Traders often encounter the use of ‘hard’ and ‘soft’ when describing commodity types.
- A hard commodity any commodity that must be mined (gold, silver) or extracted (rubber, oil).
- A soft commodity describes anything of an agricultural nature (corn, soybeans, wheat, rice).
To confuse matters even further, the word “raw” is often used, as well, more as a broad definition of any raw material used in the production of something else.
What Is the Most Valuable Commodity?
Oil is the most valuable traded commodity. Energy is known as the ‘Mother of All Markets’, and constitutes in excess of $1.3 trillion – roughly 3.6% – of global GDP. Oil tops the list of products, which can be further broken down into various crude oil qualities, heating oil, and its cousin, natural gas. Crude oil also plays a role in the production of nearly every other commodity on the planet, as well as plastics, cosmetics, pharmaceuticals fertilizers, computers, synthetic fibers, and more.
What Are the Top 10 Traded Commodities in the World?
According to data from The Futures Industry Association (FIA), the most heavily-traded commodities in the world are:
- Brent crude oil
- Steel
- WTI crude oil
- Soybeans
- Iron
- Corn
- Gold
- Copper
- Aluminum
- Silver
Commodity Risk Factors
Everything from the weather, to competition, and to inventories on hand can unduly cause extreme market fluctuations in price. These violent market swings are called volatility – a general measure of risk in any given marketplace.
Volatility – a natural prerequisite for trading gains – runs high in commodity markets. For this very reason, commodity trading is known to have a high-risk profile, which means that there is a high potential for reward, but also a high potential for loss as well.
Commodity trading requires specialized education and training, practice time on demo trading accounts, access to and assimilation of information from a variety of sources, a specific trading plan that will mitigate risk, a disciplined approach and, above all, patience. It’s also important to prevent your emotions from ever interfering with your decision-making process.
Trading Commodities Online
You now have a basic understanding of the global commodities market, the types of commodities that are traded and the exchanges that are at the core of the commodity market.
Now, it’s time to take a look at:
How you can start trading commodities online
- The best ways to trade commodities for you
- Why they are a great option for your portfolio
How to Start Commodity Trading
As with other trading disciplines, you will need a ‘partner’ in the form of a broker that offers the products, safety and security, fees, and support that you prefer. An easy-to-use trading platform can make all the difference. The “trick”, if there is one, is to find a broker that provides the right balance between fees and platform tools.
If fees are low, the platform may be meant for professionals and not suit your taste. For full-service brokers like the IG Group or Saxo Bank, a series of platforms are offered – one for each level of trading experience. In your search for a broker, be sure to check reviews of their various platforms to find one that will be comfortable and support your technical requirements.
Brokers have also adapted to today’s electronic age, and gone are the days of having to call a broker for quotes. Technology now enables trading via your desktop, smartphone or tablet and while on the go – as long as the exchange in your selected time zone is open for business. Brokers with a global presence can also provide access to foreign markets and also provide trading opportunities in the more exotic commodities.
What Is the Best Way to Trade Commodities?
The best way to trade commodities is to match your trading personality and tolerance for risk with a method that does not cause you to lose sleep at night. Depending upon your tolerance for risk and favored commodity, there are 6 ways you can trade commodities:
- Traditional stock ownership of a commodity producer
- Exchange-Traded Funds (ETFs)
- Mutual, managed, or index funds
- Contracts for Difference (CFDs)
- Options on Futures
- Futures Contracts
Ample leverage is available for the latter three methods, while basic stock margin rules apply to the first two items. There is a trend within developed economies where regulators have moved to limit the use of leverage for high-risk investment vehicles. Leverage can magnify your potential for gain, but also your potential for loss, as well. Learn to use it wisely
Can You Make Money Trading Commodities?
If a trader understands how demand and supply, along with a host of other factors, can impact commodity markets, then there are profits to be made, especially since this medium is very volatile. Current estimates are that the volatility of commodities is a “3X” multiple for that of the foreign exchange market, which is known for its violent price swings.
Many investors have found that commodities are an excellent way to diversify their portfolios since this asset class tends to act differently than others when under stress. Commodities, since they have intrinsic value priced in the U.S. Dollar, also offers a hedge against inflation.
Lastly, globalization and population growth are creating new pockets of wealth in developing economies that aspire to higher lifestyles, which can only mean that the demand for commodities will increase over time, an insightful long-term trend.
There are plenty of commodity trading tips and strategies that will help maximise your profits from trading on the commodity market.
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