When first learning, you might ask “What is commodity trading?” Whether they are part of the metals, energy or food sectors, commodities play a very important part in your life. The rising price of crude oil can increase the cost of driving your car, and more. Our commodity trading guide shows that you now have several ways to invest, even if you’re not a professional.
An important part of knowing how to trade commodities is knowing where to invest. There are many commodities exchanges throughout the world, so here’s a commodity trading explanation. Most make markets in several different types of commodities, although a few specialize in only one group. For example, the London Metal Exchange only trades in metal commodities, as you would expect given the name of the exchange. The most popular commodities exchanges in the US include those operated by the CME Group – the Chicago Board of Trade, the Chicago Mercantile Exchange, the New York Mercantile Exchange and the Kansas City Board of Trade. Another prominent US commodity exchange is the Intercontinental Exchange, which is based in Atlanta. In addition to the London Metal Exchange, other prominent international commodity exchanges include the Australian Securities Exchange and the Tokyo Commodity Exchange. Trading commodities on the exchanges requires standard agreements regarding the quality of the commodities, so you can trade them with confidence without having to visually inspect them. This way, you don’t have to worry about whether the commodities are of unacceptable or inferior quality. The basic economic laws of supply and demand are what drive the commodities markets. Lower available quantities of a commodity will increase the demand for the commodity, which will lead to higher prices. Higher available quantities will have the opposite effect – demand will decrease, resulting in lower prices.
There are four categories of tradable commodities – agricultural, livestock and meat, energy and metals. Agricultural commodities include sugar, cotton, coffee, cocoa, rice, wheat, soybeans and corn. Livestock and meat commodities include live cattle, feeder cattle, pork bellies and lean hogs. Energy commodities include gasoline, natural gas, heating oil and crude oil. Metal commodities include copper, platinum, silver and gold.
There are several common trading strategies for commodities. When stock markets become volatile or bearish, you may wish to transfer money out of the stock market and invest in precious metal commodities, such as gold. Investors have traditionally viewed gold and other precious metals as something with value that is both reliable and conveyable. You can also use precious metals as a hedge against currency devaluation or high inflation. You can also implement energy plays when you trade commodities. Changes in economic development trends worldwide or reductions in oil production can lead to rapid increases in oil prices, providing you with opportunities to evaluate how to trade commodities given the inherent conflict between limited supplies of oil and the ever-increasing demands for energy. The markets for grains and other agricultural commodities are usually very active. The markets often are very volatile during times of transitional weather and during the summer months. In addition, the combination of a growing population and limited supplies of agricultural commodities can provide you with potential trading opportunities as the prices of agricultural products increase.
When it comes to how to trade commodities, one of the most popular ways is to use futures contracts, which is a commitment to buy or sell a specific amount of a commodity at a given price at some point in the future. You can trade futures contracts on all types of commodities.
There are two types of investors who participate in the futures markets – institutional or commercial entities that use commodities in their operations and individual investors like you who wish to profit from price changes in the futures contracts. You would typically close out your position in the futures market before the due date of the contract and not take delivery of the commodity (e.g., gold, grain or oil) itself. If you decide to invest in commodity futures contracts, you will need to open a brokerage account if you don’t already use a broker that trades futures as well as stocks. Before you can trade futures, your broker will require you to complete a form that acknowledges that you understand the risks you incur when trading futures and that you have enough capital to handle those risks. Be sure to do your due diligence and conduct a broker comparison before you open an account with a new broker. Your account’s value will depend on the value of your futures contract. If the contract’s value decreases, you will receive a margin call to put more funds into your account to keep your position open.
Trading futures contracts has several advantages. First, this type of trading allows you to make a pure play on the underlying commodity. In addition, futures contracts are highly leveraged, which gives you the potential to make large profits if you have invested in the correct side of the trade. The minimum deposits required for trading futures contracts allows you to control full-size commodity contracts, and you can easily take a long or a short position. Conversely, trading futures contracts has several disadvantages. The futures markets can experience great volatility, and direct investments in the futures market can expose you to very risky situations, as the leverage associated with these trades magnifies the potential magnitude of your losses. A trade can turn against you very quickly, and before you can close your position, you could lose your entire initial deposit and possibly even more.
Most futures contracts will also include options. Purchasing an option is comparable to placing a deposit on an item rather than buying it outright. The option gives you the right to purchase something, but you are not obligated to complete the transaction. Therefore, if the futures contract price does not change in the direction you expected, your only loss is the cost of purchasing the option.
For those who asked “What is commodity trading?”, a perhaps more familiar alternative to trading in commodity futures is to invest in the stocks of companies that are related to commodities in some fashion. For example, if you wish to make a play in oil, you could invest in refineries or drillers. If you think that making a play in gold is a wise move, you could invest in smelters, refiners, or mining companies.
Equities are usually less likely to experience volatile price changes than futures. In addition, it is easy to buy, hold, sell, trade and track stocks, and purchasing stock allows you to narrow your investments to a specific sector. However, you should do some basic research to evaluate whether purchasing stock in a certain company is a good investment as well as a viable commodity play. Another method you could use to invest in commodities is to purchase stock options. Investing in stock options will require a smaller cash outlay than purchasing stocks directly. While you limit your risk to the cost of purchasing an option, the price movements of options do not typically mirror the price movements in the stock. Finally, you could invest in commodities by purchasing mutual funds that invest in stocks of businesses in commodity-related industries, such as mining, agriculture or energy, or by purchasing commodity index mutual funds that invest in derivative investments linked to commodities, or futures contracts.
Exchange-traded funds (ETFs) and exchange-traded notes (ETNs) are financial securities that trade like stocks. You can use these securities to make a play in the fluctuations of commodity prices without making a direct investment in futures contracts. Exchange traded funds (ETFs) and exchange traded notes (ETNs), which trade like stocks, allow investors to participate in commodity price fluctuations without investing directly in futures contracts. Commodity ETFs usually track the prices of a group of commodities or a specific commodity that make up an index by using futures contracts, although a few investors have backed EFTs by holding an actual commodity in storage. Perhaps the most publicized case of the latter practice occurred in 2011, when the University of Texas Investment Management Company made a currency play by placing 5% of its $21 billion endowment and other assets in its portfolio in gold bullion bars stored in a bank vault in New York. Commodity ETNs are unsecured debt instruments that are backed by an issuer and are designed to mirror the price fluctuations of a commodity index or a specific commodity. You do not need a special brokerage account to make an investment in ETFs or ETNs. Since ETFs and ETNs trade like stocks, you don’t have to be concerned about redemption or management fees. These securities give you a simple way to invest in the price fluctuations of a basket of commodities or an individual commodity.
You may also decide to entrust your investment in commodities to a commodity pool operator (CPO). A CPO is an individual or limited partnership that collects money from investors, gathers it into a common pool and invests the funds in futures contracts and options. CPOs must provide you with a risk disclosure document, periodic account performance statements and annual financial reports. They also must keep detailed accounts of all transactions they make on behalf of investors in every pool they may be managing. CPOs will hire a commodity trading advisor (CTA) to provide advice on the trading decisions they make on behalf of the pool. CTAs must register with the Commodity Futures Trading Commission (CFTC) and pass an FBI background check before they can advise CPOs on which investments to make. CTAs usually have a propriety system for trading futures and use that as the basis for providing recommendations to CPOs. Investing through CPOs provide several advantages. CPOs make their investment decisions based on professional advice provided by CTAs, and the pooled investment structure provides the CPO with a larger pool of money to invest. Also, the structure of a CPO ensures that you will invest the same amount of money as other investors in the CPO. Before investing, be sure to check the CTA’s risk-adjusted return from previous investment activities.
Hopefully, this guide has helped answer your question of “What is commodity trading?” There are many types of commodity investments that are available to you. Although the most direct way for you to invest in the commodities markets is by purchasing futures contracts, there are other forms of investments with varying degrees of risk that will allow you to participate in the price movements in the markets – this is certainly the underlying commodity trading explanation. Unpredictable changes in weather and natural disasters can quickly turn an investment in the commodities markets into a risky proposition, so you should monitor any investments you make very carefully. It’s important to have a good commodity broker that runs a robust trading platform and provides you with the data you need to quickly make informed decisions. Your commodity broker acts as the intermediary between you and the exchanges on which the commodities trade. The broker makes the commodity investment process more orderly by providing the experience, technology and regulatory knowledge and monitoring that you need.