Commodity trading is an investing strategy wherein goods are traded instead of stocks. Commodities traded are often goods of value, consistent in quality and produced in large volumes by different suppliers such as wheat, coffee and sugar.
Trading is affected by supply and demand, thus, limited supply causes a price increase while excess supply causes a price decrease.
Commodities markets, both historically and in modern times, have had tremendous economic impact on nations and people. The impact of commodity markets throughout history is still not fully known. Shortages on critical commodities have sparked wars throughout history (such as in World War II, when Japan ventured into foreign lands to secure oil and rubber), while oversupply can have a devastating impact on a region by devaluing the prices of core commodities.
Energy commodities such as crude are closely watched by countries, corporations and consumers alike. The average Western consumer can become significantly impacted by high crude prices. Alternatively, oil-producing countries in the Middle East (that are largely dependent on petrodollars as their source of income) can become adversely affected by low crude prices. Unusual disruptions caused by weather or natural disasters can not only be an impetus for price volatility, but can also cause regional food shortages.
The four categories of commodity trading include:
– Energy (including crude oil, heating oil, natural gas and gasoline)
– Metals (including gold, silver, platinum and copper)
– Livestock and Meat (including lean hogs, pork bellies, live cattle and feeder cattle)
– Agricultural (including corn, soybeans, wheat, rice, cocoa, coffee, cotton and sugar)
Commodity trading in the exchanges can require agreed-upon standards so that trades can be executed (without visual inspection). You don’t want to buy 100 units of cattle only to find out that the cattle are sick, or discover that the sugar purchased is of inferior or unacceptable quality.
There are other ways in which trading and investing in commodities can be very different from investing in traditional securities such as stocks and bonds. Global economic development, technological advances and market demands for commodities influence the prices of staples such as oil, aluminum, copper, sugar and corn.
Commodity trading in the financial markets can work in two different ways. Traders can trade commodities based on current spot price (e.g. Spot Gold, Spot Silver) and make, or lose, money depending on whether the price moves for or against their position. Spot positions have no expiry date, meaning you can hold your position for as long as you want to. This can be done through CFDs.
Traders can also opt for a future contract as well. Unlike a spot position, a future contract will expire at a specified future date. The value of a future contract will be derived by how much the commodity is priced in the future contract, compared to the spot price at that point in time.
Future contracts are highly standardised and traded through dedicated exchange that ensures all contracts are marked-to-market daily.
Similar to all types of financial instruments, there are risks involved when it comes to commodity trading. Here are the four main risks that potential traders should be familiar with:
– Demand & Supply: Since all traded commodities are used, the prices of commodities can swing widely based on whether demand excess supply, or vice versa.
– Weather: For soft commodities such as wheat, cocoa and coffee, prices can increase if poor weather limits supply for a particular time period, since consumer demand for these goods are likely to remain constant.
– Political Development: Political developments can cause price fluctuations.
– Exchange Rate: Like it or not, most commodities are priced in US Dollar (USD). For Singaporeans, what that means is that the performance of our Singapore Dollar (SGD) against the USD also matters to us, since any potential gains in our trades may be offset if the exchange rate moves against us.
One of the main reasons why financial traders are keen to trade commodities is because of price volatility.
Due to the various risks mentioned above, prices can fluctuate significantly in the short run thus allowing for profits to be made, assuming a trader takes the right position. By employing leverage, profit margin can increase further.