What is Commodity Trading?- Types, Trading Tips, & More

Are you looking for an exciting way to make trades and increase returns? Commodity trading may provide just the opportunity that fits those needs. According to research, S&P GSCI had a strong performance in 2022, with a 26% increase. This outperformed other asset classes for the second year in a row. 

So, what does this mean? It means that when market conditions are favorable, investing in commodity markets can be a great choice. Let’s learn more about these markets in detail.

What are Commodities?

Commodities are physical goods typically used in production or consumption. They include:

• Agricultural products, such as wheat, corn, and soybeans
• Metals, like gold, silver, and copper 
• Energy sources, like oil, natural gas, and coal
• Livestock, such as hogs, chickens, and cattle
• Processed foods, like sugar beets, milo maize, etc. 

What are the Major Types of Commodities?

The following are the four major types of commodities.

Metal Commodities

This includes commodities, such as gold, silver, platinum, and copper. They are obtained from natural sources through mining or processing activities, with prices often fluctuating based on supply/demand dynamics. 

For instance, Gold has been highly valued since ancient times and is used as a store of value in investment markets around the world. It comes from natural sources through mining or processing activities and usually ranges anywhere between 24-22 Carat (with different percentages of purity). 

Energy Commodities

This includes crude oil, heating oil, natural gas, and gasoline. Oil is one of the most important energy commodities in existence and is used to power most of modern life. It comes from natural sources through drilling or refining processes but can also be created synthetically with a variety of technologies like biomass-to-liquid conversion methods. 

The global market for petroleum products is incredibly vast, especially due to its many different uses. These include:

• Fuel for motor vehicles and ships
• Chemical feedstock (chemicals derived from refined oils)
• Lubricants
• Insulation materials
• Asphalt paving material
• Heating fluids

Livestock and Meat

Rearing animals for human consumption forms a major part of the commodities market. This can be split into livestock, such as cows, sheep, etc., along with their processed equivalent meat products like beef/mutton. The global demand usually drives prices up. This makes it an attractive investment option.

Agricultural Produce Commodities

This commodity type constitutes all types of agricultural products, such as grains, fruits, and vegetables. It also includes processed food items like dairy products, eggs, and canned goods along with non-food items made from raw materials and consumed by humans and/or animals. 

The global market for this commodity is incredibly vast. Prices can often vary, depending on environmental factors (weather conditions) or supply/demand dynamics.

You can learn more about the community market dynamics, you can opt for this in-depth stock market trading course.

How Does Commodity Trading Work?

Commodity trading involves trading either through physical goods or derivative contracts. In physical commodity trading, the commodities are bought and sold in spot markets, and the transaction is immediate. In derivative contracts, the value is derived from the underlying commodities. The contracts specify that traders will buy and sell the commodities in specific quantities at a predetermined price on a future date. 

Supposedly, a trader buys a derivative contract for a commodity at a specific price. They will initially pay only the margin. If the price increases the next day, the amount made on the increase will be credited to the bank account linked to the commodity market. However, if there is a drop in the price, a certain amount will be debited from that bank account. 

The commodity market offers high leverage but is subjected to fluctuations and should be handled properly, keeping the associated risks in mind. 

What are the Different Techniques of Commodity Trading?

There are different ways of commodity trading. Given below are some of them:

Invest with Futures

Commodity traders can gain exposure to the asset class through futures contracts. These agreements between two parties involve one side buying and receiving delivery of a commodity at an agreed-upon price on a future date. However, the other is obligated to sell it according to exchange regulations. 

Commercial entities like airlines buy these futures as hedges against market swings for a steady supply. Meanwhile, farming cooperatives use them to guard against losses from raw material hikes. 

Physical Commodity

For precious metals, such as gold and silver, individual investors may opt for physical commodity purchases, which allow them to take possession of these assets, like bars, coins, and jewelry. This strategy lets you have direct control over investments with tangible results. However, transaction costs are usually more expensive than other means when dealing with value-dense items like gold, silver, or platinum.

Commodities Stocks

Commodity stocks offer less risk than direct investments in commodities. This is because their performance is contingent, not only on the price of the underlying commodity but also on other factors, such as company management and total market share. For example, to invest in oil, you could purchase stock from an oil refining or drilling firm. 

Investing with ETFs and ETNs

Investors can use exchange-traded funds (ETFs) and exchange-traded notes (ETNs) to enter the commodities market. This allows them to potentially profit from price fluctuations without owning futures contracts. ETFs track particular commodities or indexes with futures contracts, while ETNs are debt securities that attempt to mimic commodity prices. 

Both trade like stocks and do not require special brokerage accounts. However, any changes in the price of a commodity may not be mirrored by its related ETF or ETN. There is added credit risk when investing through an ETN as they are backed by their issuer.

Using Mutual and Index Funds to Invest in Commodities

Investing in commodities using mutual and index funds can provide investors with professional money management, added diversification, and liquidity. However, customers cannot invest directly in the commodity. Instead, they must look for stocks of related industries such as energy or mining.

Commodity Pools and Managed Futures

Investors may use commodity pools and managed futures to invest in commodities. CPOs are responsible for gathering funds, distributing statements/reports, managing records of investments/transactions, etc., with the help of a registered CFTC-approved trading advisor (CTA). Investing in this way allows investors access to professional advice from CTAs. These funds can be highly risky but potentially have higher returns than ETFs or mutual funds. This is because of the complex strategies used by managers.

Commodity Trading Vs Stock Market Trading: A Comparative Analysis

Some of the differences between commodity trading and stock market trading are as follows:

Parameters	Commodity Trading	Stock Market Trading
Trading Hours	The commodity market is open twenty-four hours, seven days a week.	Stock market trading is done only during business hours, i.e., when the stock exchange opens.
Leverage	It relies on leverage more than the stock market. The investors invest by paying a margin of the total amount.	It relies less on the leverage than the commodity trade.
Effects of Inflation	Prices of commodities rise significantly.	Prices of stocks and bonds fall during inflation.
Duration	The investments made in commodities are usually short-term investments.	Investments made in stocks and bonds are held for long periods to reap profits.
Returns	Investments in commodities, especially in energy resources and precious metals, generate significant returns.	Stock market trading generates returns but is subjected to market fluctuations and is less profitable than commodity trading.

Tips to Start Commodity Trading

Trading commodities can sometimes be very risky. However, here are some tips that can ensure success. 

• Study and understand the repeating market cycles. This will help you know how to invest. 
• Follow and understand economic news. It will help you prepare for the Black Swan events. The Black Swan event is a market crash or an unexpected market event. 
• Understand that each commodity has a different volatility level. It will help you know which commodities to trade in as higher volatility markets are usually more risky. 
• Make use of “Stop Loss” and avoid overtrading. This is because some markets can be very volatile or risky. So, trading less and placing a stop loss on every trade will help you reduce your losses.

Why Should You Invest in the Commodity Market?

The importance of investing in the commodity market lies in its benefits. Some of them are as follows:

• Substantial Returns: The investors gain substantial returns by investing in volatile commodities. With correct speculation skills, an investor can leverage the price volatility of these commodities and make profits.
• Protection Against Inflation: The price of commodities, such as gold, rises during inflation. As opposed to stock investment, the investor can benefit from the rising inflation. Commodities with stable prices also provide a safe investment against market fluctuations in the long run. 
• Diversification: Investing in commodities allows investors to diversify their portfolios. It is because the raw materials have a negative to low correlation with the stocks and bonds. 
• Transparency: The highly regulated commodity market run-through electronic trading suite has reduced the risk of manipulation, increasing transparency in the system. 
• Margin Trading: Various participants in the commodity trade benefit from the margin. The traders can take a significant position in the market by paying up to 10% margin. It allows them to increase their profit potential. The hedgers and speculators profit from transactions where trading happens through borrowed funds. Investments such as physical delivery of bulk orders with a promise of repayment at a later date give both traders and speculators higher returns. 

Drawbacks of Commodity Trading

Before you begin your investment journey, be aware of the limitations of commodity trading. These are as follows:

• High Risk: There is high volatility in the commodity market. Due to fluctuations in production, demand, or the occurrence of any social changes, the prices of the commodities are affected. It becomes a challenge for the investors to predict the prices of the commodities, which can lead them to face losses.
• Leverage: It allows the investors to invest and make big bids in the market at lower prices, but there is a risk of losing money with the slightest fall in the prices of the commodities. 
• Limited Returns: An investor will only get capital gains on the investment made through commodity trading since there are no periodic payouts. 
• Less Diversification: Commodity trading leads to higher asset concentration in one segment since the investment tools concentrate on one or two industries. It does not leave room for much diversification in the portfolio. 
• Buy-and-Hold Investors Gain Less: Because products are susceptible to rise and fall in demand and supply, the value of the investment with the buy-and-hold investors decreases over time.

Conclusion

Commodity trading can be a great way to diversify your portfolio and invest in physical goods, such as metals, energy sources, like oil or gas, livestock products, and agricultural produce. Knowing the characteristics of the commodity market allows traders to understand how prices change based on supply/demand relationships which are key for successful speculation over time. Since commodity trading is a highly volatile market, understanding hedging strategies in stock market can be of great benefit, especially if you’re a beginner.

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