Different variety of commodity trading

Commodities are raw materials used to manufacture refined goods. This is one of the most popular trading instruments among beginners and experienced participants in the financial markets. Much like stock trading, where you can buy and sell shares of companies, you can buy and sell commodity products.

Commodities futures are traded on most stock exchanges, including the New York Stock Exchange (NYSE), NASDAQ, London Stock Exchange (LSE) and others. Traders and investors can choose from various commodity trading formats, including CFDs and futures trading, investing in commodity stocks, spot buying and more.

Accordingly, a variety of trading strategies and tactics can be used in the commodities market.  But let’s start from the very beginning.

What are Commodities?

Resources like coal, gold, oil, and others are called commodities because they're used to create consumer goods. Simply put, raw natural resources found in nature are known as commodities.

Commodities are an important area of the financial industry. They can be bought and sold on specialized exchanges as financial assets. There are also well-developed derivatives markets where you can buy contracts on these commodities (e.g., forwards, futures, and options).

The basic principles of supply and demand are used to explain changes in commodity prices. Low supply equals high prices, so any major disruptions on the supply side — such as widespread health issues that impact cattle — can lead to spikes in demand and price for livestock.

For a better understanding of the basics and diversity of commodity trading, let's look at the categories of this type of asset.

Types of Commodities

Commodities generally fall into one of three categories. Metal, energy, and agriculture are the three broad categories.

Agricultural

Agricultural commodities include raw products such as soybeans, corn, sugar cane, coffee beans, wheat, and cotton. Grains can be volatile during the summer months or when weather-related transitions take place. For investors interested in the agricultural sector, whether due to population growth or limited supply, there are plenty of potential opportunities from rising commodity prices.

Metal

Metal commodities include gold, silver, platinum, and copper. During periods of market volatility or a bear market, some investors choose to invest in precious metals — particularly gold — because it's considered to be a reliable "store of value". Investors will also often choose to invest in precious metals during periods of high inflation or currency devaluation as a hedging strategy.

Energy

Energy commodities include heating oils, natural gas, and gasoline. Global economic developments and reduced oil outputs have led to a rise in the price of fuel, as global demand for energy-related products has increased while supplies have dwindled.

Investors should be aware of developments that can have a huge impact on the market prices for commodities in the energy sector. These include:

• Economic downturns, politics, geopolitical tensions, and others.
• Supply and demand economics, typically enforced by the Organization of the Petroleum Exporting Countries (OPEC).
• Advances in alternative energy sources such as wind power, solar energy, biofuel, and so on.

A History of Commodities Trading

As we already mentioned, commodities are the tradeable raw material that people have been trading for millennia. Many countries have gained power, importance and increased longevity because of the ability to manage their commodities market successfully.

Today, global commodity trading happens via commodity exchanges. A commodities exchange refers to both a physical location where trading of things takes place and companies that have been created to enforce standardized prices for commodity contracts.

However, many commodities exchanges have recently merged or gone out of business, being largely replaced by stock exchanges.

Nonetheless, you can still find the major commodity exchanges in the world's financial capitals. These include the Chicago Mercantile Exchange (CME), New York Mercantile Exchange (NYMEX), Intercontinental Exchange (ICE), London Metal Exchange (LME), Tokyo Commodity Exchange (TOCOM) and others.

How are Commodities Traded?

There are several variations of commodity trading in global financial markets: CFDs, futures contracts, stocks of commodity companies, bonds, and options. Let's look at all the available tools for trading and investing in this asset category.

Using Futures to Invest in Commodities

If you want to invest in commodities - like crude oil, copper, and soybeans - one way is through futures contracts. A futures contract is a legal agreement to buy or sell an asset at an agreed-upon price and time in the future.

There are two types of people that invest in commodity futures markets: commercial or institutional users of the commodity and speculative investors.

A company's futures contracts play a role in its budgeting process by helping to control for changes in expenses and providing liquidity as needed. Manufacturing companies that rely on commodities may use commodity markets to reduce risk due to changing prices. The same applies for farming cooperatives and many other businesses.

Futures contracts allow businesses to hedge against risks, such as volatile prices or weather conditions, that might have otherwise bankrupted the company. Many businesses depend on predictable pricing. However, it should be noted that the opposite is also a possibility.

For example, let’s say Bob agrees to purchase crude oil from company XYZ at $70 per barrel in August 2023. This might seem like a reasonable price given the current economic conditions. But in the beginning of 2023, a major global event impacts the supply of crude oil and prices jump to $120 per barrel by August. When the agreement is executed in August, Bob will have saved $50 per barrel, while company XYZ will have incurred a loss of $50.

The scenario we just looked at describes what happens to commercial or institutional users who trade commodities. In the next example, we will look at how it affects speculative investors who aim to profit from a change in the price in the short-term.

Because they do not rely on the actual goods they are speculating on, these traders close out their positions before the futures contract is due and never take actual delivery of the product they're speculating on.

Futures contracts are risky due to their leverage as small changes can lead to large swings in price. So, investors need to be very careful when trading this asset. When trading commodity futures with a broker, if the value of your futures contract drops and you do not have enough funds to make up for it, you may be subject to a margin call and required to deposit more money into your account.

On the other hand, futures contracts can be an excellent way to participate in the commodities market, with many benefits that draw investors in. One advantage is that futures analysis is typically simpler because it's a pure play on the underlying commodity. Another advantage is that you can speculate on full-sized contracts which might otherwise be difficult to afford. Finally, futures are derivatives which means that investors can take both long and short positions on this asset.

Using CFD to Trade Commodities

One of the most popular formats for trading commodities is Contracts for Difference (CFDs). Traders worldwide often use CFDs for trading commodities because they allow trading on margin. 

Margin trading allows investors to participate in a trade having deposited only a part of the total value of the trade. This allows them to open positions that they wouldn't normally be able to. Trading on margin increases the potential for profits, but also for losses. Much like futures, CFDs are risky and investors are only advised to invest money that they can afford to lose.

Trading commodity CFDs means that investors speculate on the price of the underlying asset, without ever having to take ownership of it. But, as is the case with most derivatives, the most appealing aspect is that investors can potentially profit from both rising and falling prices. In other words, they can long or short any given commodity CFD.

Using Stocks to Invest in Commodities

Many investors are interested in entering the market for a particular commodity, such as oil or gold. Some invest in the stock of companies related to that commodity. For example, those interested in the oil industry may invest in drilling and tanker companies, refineries, or diversified oil companies. Those interested in the gold sector may have different options - like investing in mines, smelters, or any firm dealing with bullion.

There are pros and cons to investing in stocks to gain access to the commodities market.

One of the advantages of buying stocks is that they are liquid. Another advantage is that an investor does not have to buy large quantities of commodities with their investment since a stock represents a fractional share in a company.

A disadvantage is that stocks are significantly more expensive than most commodities, making it difficult for investors who want to simultaneously follow the movements of many commodities. Finally, stocks may be influenced by company-related factors that have nothing to do with commodity prices, which means investing in them may not be as valuable for commodity price prediction as other investments.

Conclusion

Depending on the type of trader you are and the amount of risk tolerance, there are different ways to invest in the commodities industry. You can take a direct approach with commodity futures contracts or choose an investment with less risk that still provides opportunities for exposure to commodities.

Commodities are known to be risky investment propositions because they can be affected by uncertainties that are difficult or impossible to predict, such as unusual weather patterns, geopolitical tensions, epidemics, and natural disasters.

However, diversifying your risks and using different types of trading with a reliable broker will help you reduce your risks and get more out of this potentially promising asset class.