Commodity trading explained

The global commodity markets are some of the most active among all financial exchanges. Everyday billions of dollars in commodities change hands. This page provides readers with a clear understanding of what commodities are, how they are traded and the various options available for investors looking to gain exposure to commodities.

What is a commodity?

Commodities are raw materials predominantly used for consumption, production, manufacturing, and energy. Commodities are often considered the bedrock of financial markets as they drive all physical movement within the global economy.
Such is the importance of commodities to daily life; their price movements are always considered significant. Of all commodities, crude oil has the world’s highest trading volume. Crude oil is also considered the most important of all commodities, as it is the lifeblood of the industrialised world. Oil powers global transport, heats, and cools homes, creates electricity and forms important materials, including plastic and other oil-based goods.
Of course, crude oil is just one of many essential commodities, each with their own specific utility. The below table provides a list of the world’s most highly traded commodities by volume
Commodity Average Daily Volume (ADV) Open Interest
Crude Oil (WTI) 687,479 2,187,168
Corn 582,269 1,505,976
Henry Hub Natural Gas Future 466,455 1,233,792
Soy Beans 192,684 807,569
Chicago SRW Wheat Future 134,676 357,978
Source: Investopedia

Economists often place commodities into three broad categories: energy, agriculture, and metals.

  • Energy commodities: crude oil, natural gas, petroleum.
  • Agricultural commodities: soy, dairy, hay, eggs, wheat.
  • Metal commodities: iron, steel, gold.

What drives price movements in commodity markets?

The value of commodities rise and fall daily. There are several factors which can impact the price movements. Below we use oil as an example of how supply and demand pressures affect the commodity’s price.

Supply increase

Crude oil prices may fall upon the news of a new drilling technology which will increase supply. Similarly, discovering a new recoverable oil basin may push down prices.

Supply decrease

The Organisation of the Petroleum Exporting Countries (OPEC), issues regular press releases on supply. If OPEC decides to curtail production, the price of oil will increase. OPEC’s production targets allow them to enjoy a significant amount of price control.

Demand increase

The climate has a significant impact on oil prices. The Northern Hemisphere is home to roughly 90% of the world’s population. When there is a particularly cold winter in the Northern Hemisphere, energy usage increases significantly for heating and transportation. Oil prices will increase on the back of long-term weather forecasts, which predict colder weather.

Demand decrease

During the COVID-19 pandemic, movement was restricted significantly. Planes were grounded, ships were docked, trains remained stationary, and cars sat parked. As the world came to a sudden halt, the demand for oil plummeted. As a result, the price of oil fell sharply as stockpiles increased.

Capitalising on price movements of commodities as an investor

As with any asset class that experiences regular price volatility, there is an opportunity for investors to trade and profit from the ever-changing prices; there is also the very real danger of making a loss to account for. Even the most experienced and knowledgeable traders can experience losses when trading commodities due to the often-unpredictable nature of the price movements. It is widely agreed that trading commodities carries a greater amount of risk than conventional assets, including stocks and bonds.

What commodities are a good investment?

As discussed above, commodities rise and fall in value based on supply and demand. The factors which impact supply and demand change on a daily basis meaning that what could be considered a good investment on a particular day, may indeed change quickly. Commodity trading is not often considered a ‘buy and hold’ play, as the greatest rewards are normally reaped on a short-term basis. As a result, commodity trading is rarely advisable for retail investors. That is not to say that commodities have no value for retail investors; on the contrary. But the dangers of day-trading in the commodity market are often considered too risky.

How a commodity market works

The commodities market operates in the same way as any other financial market. The most common way for traders to buy and sell commodities is by buying and selling futures contracts.

Futures contracts explained

A futures contract is a legal agreement to buy or sell a particular commodity at a predetermined price on a specific date.
This means that traders are able to lock in the price of an underlying asset or commodity. For example, if Brent crude oil futures contracts are selling for $95 a barrel, a trader may wish to purchase the contract. If the price of Brent crude oil then increases in the coming days and weeks, the value of the trader’s futures contract will increase in value. Therefore, if the trader believes oil will increase in value in the near term, they will be likely to purchase futures contracts with the hope or expectation they can sell them for a higher price.
As the contract is an agreement for the purchasing of oil at a certain price on a certain date, the contract holder must be ready to take delivery. In terms of the purchasing of futures contracts, there are two main types of traders in the futures market: those who are trading to create financial gain for investment institutions like hedge funds, and those working for companies who require physical delivery.
For traders working for financial institutions, it is imperative that they offload the contract before the delivery date. As the contract is a promise to buy the predetermined amount, the trader must accept delivery. This could in theory, result in oil trucks parking up outside a hedge fund or investment bank.

Investing in commodities

There are a variety of ways that individuals/retail investors can invest in commodities. Investors can purchase the physical commodity; this is most common with precious metals, for example, gold. Investors can purchase an ETF which tracks the price of futures contracts; the majority of major fund houses will offer ETFs for commodities. Investors who believe the price of a commodity will increase can purchase an ETF. Investors can also choose to enter structured products which pay quarterly coupons based on the price of commodities. These are advantageous for investors looking for a pre-defined income/return. Click here for details on how to open a structured products trading account.

How to invest in commodities

With that in mind, for retail investors, it is often advisable to mitigate risk by employing a more diversified approach to investing in commodities. Using diversified commodity ETFs or structured income products allows investors to reduce potential risk.
Investing in commodities is a complex environment, and retail investors should seek professional advice before making decisions. Whether or not commodities are suitable for an investor’s portfolio depends on several factors, including investor objectives, capacity for risk, and available liquidity and time horizon, among other important factors. If you would like to arrange an introductory call with a financial advisor, please click on this link.
Further reading related to commodities

What are derivatives?

It’s important to understand the term derivative within the context of commodities. Derivatives are a contract where the price is worked out by valuing the underlying asset, which in this case would be a commodity. Derivative contracts can be traded by two or more parties.

What are CFDs?

CFDs are a type of derivative that pays the difference in settlement price between the opening and closing of a trade.

What is the world’s largest commodities exchange?

The world’s largest commodities exchange is the Chicago Board of Trade (CBOT). The exchange has been in operation since 1848, making it one of the world’s oldest futures and options exchanges. In 2007 the exchange merged with the Chicago Mercantile Exchange, to form CME Group. There are other significant commodity markets, for example, the MCX commodity exchange in India and the New York Mercantile Exchange.

What is a spot market?

A spot commodity is different from a future or a derivative as it is traded on its cash value, rather than its future value. Spot markets are those whereby transactions are settled either instantly or within a few days. Traders will often use a combination of both spot commodities and futures contracts. This type of trading is more common on stock markets.

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