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How to Trade Commodities – Ultimate Guide 2020

Know everything about trade commodities and how to invest in them.
Tony Vazz
Author: Tony Vazz
Last Updated: February 20, 2020

Trading commodities is one of the most popular ways of profiting from the global exchange of goods.

Commodities are a great asset to diversify your portfolio and benefit from changing macroeconomic trends.

To be a profitable commodity trader, you need to understand all the different commodities and how they interact with each other, as well as the investment vehicles and your disposal.

In this article, you’ll find all you need to know about what are commodities and how to invest in them.

Ready? Let’s go. 

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What are commodities?

Commodities are raw materials and basic goods used in commerce and industry to build more complex products and services.

Commodities are fungible, which means that they can be standardized and exchanged among them. This means that, for instance, two tons of wheat will have almost the exact same price anywhere on the planet.

One particular characteristic of commodities is that they are produced and traded in large quantities, guaranteeing a global supply and enough liquidity for the market.

There are four main types of commodities:

  • Energy: these commodities include crude oil, electricity, natural gas, coal, uranium, gasoline, heating oil, and ethanol. Energy commodities have a massive impact on the production, distribution, and price of other commodities.
  • Agricultural: all food crops (wheat, corn, soybeans, barley…), industrial crops (cotton, rubber, lumber…) and livestock (cattle, poultry, hogs…).
  • Metals: precious metals (gold, silver, platinum, and palladium) and base metals (iron ore, steel, aluminum, nickel, zinc, tin…).
  • Environmental credits: this is the newest category of commodities, including carbon emissions, renewables energy certificates, and energy-saving certificates.

How commodities work

Depending on the category, each commodity will have particular factors that influence its supply and impact its price.

The main factors that drive commodity prices are:

Supply

Like any other asset in the market, commodity prices are inevitably driven by the available supply at a given moment.

If you want to trade agricultural commodities, you have to bear in mind crop yields, climate episodes like floods or droughts, global politics, and labor issues. For instance, if French winemakers go to strike, it may affect wine prices globally.

Demand

The other side of the coin of commodity prices is global demand. In the case of the commodities, you have to consider which economies are more dependent on raw materials, as well as those countries who produce them.

A good example of this is China, a populous country that is rapidly becoming wealthy. A downturn in the Chinese economy would affect commodity prices globally, hugely in countries that export raw materials to the Chinese market, like Australia.

Weather

Weather is a massive force in determining the supply and demand of commodities.

Heatwaves trigger the use of air conditioning, shooting up the demand for electricity. Hurricanes impact oil drilling and transport. Too much rain, or too little, impact crop yields.

You better keep an eye on the weather news if you want to be a profitable commodity trader.

US Dollar

The American Dollar has been the world’s currency reserve for a few decades, so its performance has always an impact on commodity prices.

A strong dollar translates in lower commodity prices, as countries producing raw materials get fewer dollars for their sales. A weak dollar, in return, leads to higher commodity prices.

Substitution

When possible, the market players will try to use the cheapest commodity available.

You can’t use zinc instead of gold, but silver does the trick. A spike in the price of soybeans may translate into farmers switching to corn to feed their cattle. You have to bear in mind this economic principle if you plan on investing in any commodity.

Why you should consider trading commodities

The three main reasons for getting now into commodity trading are portfolio diversification, hedge against inflation and population growth.

Portfolio Diversification

Most investors have their portfolios filled with stocks and bonds. Adding some commodities makes your portfolio much versatile against possible macroeconomic swings.

Inflation Hedge

We have seen the central banks around the world keeping a low-interest rate policy during the last couple of decades. This keeps inflation down, creating bubbles in assets like stock.

Sooner or later, the world will enter an inflationary season, and this will drive commodity prices up.

The rise of new geopolitical powers like China, the EU and India, and a multipolar world may weaken the current system of American dollar hegemony. A weaker dollar will most likely shoot up the price of most commodities.

World Population

If the two previous points weren’t enough, check out the estimated population by the UN:

Even in the most conservative estimates, we will have around 9 billion people by 2050. Just by itself will drive up the price of crops, cattle, and textile-related crops.

As emerging countries grow wealthier. Their population will start consuming at the level of current rich countries.

Another issue to consider is the rapid rate of urbanization in the developing world. As millions of people leave the countryside to live in big cities, the demand for metal and energy will shoot up.

The pros and cons of commodities

 

Pros

  • Commodities help diversify your portfolio
  • The prospects for growth are great
  • Plenty of options where to invest
  • Higher volatility than stocks and bonds
  • Easy access to trading them via derivatives

Cons

  • You have to consider tens of factors
  • Technological developments constantly influence commodities

 

How to trade commodities

There are many strategies to trading commodities, but if you are a starter, you should focus on these two:

Fundamental Analysis

Traders use fundamental analysis to identify which factors influence the forces of supply and demand.

As mentioned above, commodities are impacted by tens of factors, so it’s imperative to do deep research to identify opportunities with strong fundamentals.

Fundamentals that affect commodities are, above all, production levels. Inventories and production output are great fundamental tools.

Macroeconomic data, like GDP growth, unemployment or interest rates offer solid data for fundamental analysis.

Technical Analysis

Some traders believe that fundamental analyses are not important, as the market has already priced them. They focus on studying price charts to identify price levels that were reactive in the past and maybe so again in the future.

There’s plenty of literature around technical analysis, if you are totally new, you can start here.

There is a big debate within the trading community about which kind of trading is better, although most traders use them both in a hybrid model.

Ways to trade commodities

There are plenty of options to trading commodities, here’s a list of the most popular:

InvestmentStorage CostsExpiration DateManagement CostsLeverageRegulatedComplexity (1= easy, 5 = hard)
Physical DeliveryYESNONONONO5
CFDsNONONOYESYES3
FuturesNONOYESNOYES5
OptionsNOYESNOYESYES5
ETFsYESNOYESNOYES2
SharesNONONOYESYES2

 

Physical Delivery

You can buy any commodity and store it, although this may be unrealistic for retail investors. Purchasing large quantities of commodities require storage costs, as well as insurance and management.

A way of achieving this would be purchasing gold bars, but even this would require a certain level of secure storage.

Futures

Futures are contracts that specify a date and price for buying or selling a certain amount of a given commodity. These contracts typically involve large quantities of product and high margins.

Commodity futures are reserved for professional traders, although retail investors can access this trade via Commodity CFDs.

futures commodity trading

Options

As with most options contracts, the trader is buying the right to buy or sell some commodity at a given price during a given period of time, but not the obligation. Options contracts are paid at a premium price and their underlying asset is commodity futures, rather than a physical commodity itself.

ETFs

Like any other Exchange-traded fund, Commodity-based ETFs are funds that track the performance of futures or a group of equities.

ETFs have become a popular investment, in part because they generally don’t invest in securities, hence commodity ETFs are not regulated as investment companies.

There are some ETF that follows what is called a basket of commodities, which reduces the risk of putting all the eggs in the same basket.

Shares

This is one of the most traditional ways of investing in any commodity. Here you just buy equity on companies with the aim of obtaining a profit after the appreciation of the shares. This can be any company, from a farm to an oil refinery.

CFDs

CFDs are contracts that exchange the difference between the entry price and the exit price on a trade. CFD stands for “Contract For Difference.”

Oil CFDs are very popular because they enable every investor to speculate on the fluctuations of the commodity price with small contract sizes. CFDs are usually free of commission and borrowing costs, as there is no ownership of the underlying asset.

The way CFDs work is that the investor borrows some money to increase the exposure to the asset, in the hopes that the price will move in their favor and they could exit the trade making a profit out of the spread.

The formula to calculate the total value of a CFD is as follows. The below is NOT a trading recommendation. Do your own research before investing.

For this example, let’s assume that the price of a metric ton of wheat is $200. The standard number of metric tons in a contract is 100, and you want to buy 10 long CFDs at a 5% margin because you’re confident that the price will go up.

You’ll need to have a balance of $10,000 in your account to execute this trade. This will allow you to control $100,000 worth of wheat (10 contracts of 100 barrels each).

Let’s say that the price goes to $210. Now you control $105,000 of wheat, and you exit the trade, having made a profit of $5,000. Bear in mind that if the price goes down instead, the same rule of leverage works against you and you may lose some of your money or, in the worst case, your account may get liquidated.

If you want to try a CFD provider, we recommend you to have a look at Plus500.

FAQs

What commodity traders do?

A commodity trader is an individual or business that focuses on investing in physical substances like oil, gold, or agricultural products. The day-to-day buying and selling are often driven by expected economic trends or arbitrage opportunities in the commodities markets.

What is the meaning of commodity trading?

Commodity trading is very similar to stock trading or bond trading, with the difference that in this case, the trader operates with a range of raw materials known as commodities.

How much money does a commodity trader make?

According to a report published by the HC Insider in 2013, commodity traders with around three years experience earned an average salary of $100,000 to $150,000. Traders with more than five years experience had average base salaries of $200,000 to $350,000.

Are commodities high risk?

Commodities are risky assets. Like any other type of trading, you should do thorough research before investing your hard-earned cash. This is especially important when trading commodity futures markets, where the leverage afforded by margin makes price risk the danger on which most people focus.

 

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All trading carries risk. Views expressed are those of the writers only. Past performance is no guarantee of future results. The opinions expressed in this Site do not constitute investment advice and independent financial advice should be sought where appropriate. This website is free for you to use but we may receive commission from the companies we feature on this site.
Tony Vazz

Blockchain enthusiast and crypto fanatic. Reporting how DLT is changing the world and improving human relationships

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