What is commodity trading?

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Commodity trading is an exciting and sophisticated type of investment.  While this type of trading has many similarities to stock trading, the biggest difference is the asset that is traded.  Commodity trading focuses on purchasing and trading commodities like gold rather than company shares as in stock trading.  Like stocks, commodities are traded on exchanges where investors work as a team to purchase or trade products in an attempt to generate profit from the fluctuation of market prices or because they need that particular product.

The commodities market works just like any other market. It is a physical or a virtual space, where one can buy, sell or trade various commodities at current or future date. 

One can also do commodity trading using futures contracts. A futures contract is an agreement between the buyer and the seller, wherein the buyer promises to pay the agreed-upon sum at the moment of the transaction when the seller delivers the commodity at a pre-decided date in the future. 

The Definition, Marketplace and Players of Commodity Trading

A commodity is either grown or produced naturally in the environment.  Some examples of commodities include platinum, gold, cotton, wheat, cattle, lumber, oil, orange juice, pork bellies and sugar.  Generally, the most traded commodities are oil, gold and silver and are included in both international and national marketplaces along with a variety of other commodities. The prices of these commodities are primarily based on their demand and supply.  Traditionally, large businesses have been the main participants in the commodities market.  However, there are many individuals investors who now have access to this market via the internet.  Large businesses and companies need commodities to operate – clothing manufacturers require cotton, supermarkets and restaurants need cattle and construction companies need lumber.  One of the largest commodity exchanges is the New York Mercantile Exchange

Individual Investors and Commodity Trading Methods

With the advent of the internet and online brokers, individual traders can now get involved in the commodities market.  These individual investors do not need these commodities as companies do.  Therefore, the reason that they trade commodities is to generate a profit.  Investors, just like companies or other investment institutions, are able to make a profit from the changes in commodity prices.  In order to make a profit from the commodities market, investors must purchase or trade the commodity at the correct time depending on the increase or decrease in price.  There are several methods that investors can use to trade commodities.  First, commodities can be traded in futures – these are contracts that direct the purchase or trade of a commodity at a certain price.  Commodities can also be traded with options – this means the commodity is purchased or traded at a particular date and price.

Commodity trading in the exchanges can require standard agreements so that trades can be confidently executed without visual inspection. For example, 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.

Basic economic principles of supply and demand typically drive the commodities markets: lower supply drives up demand, which equals higher prices, and vice versa. Major disruptions in supply, such as a widespread health scare among cattle, might lead to a spike in the generally stable and predictable demand for livestock. On the demand side, global economic development and technological advances often have a less dramatic, but important effect on prices. Case in point: The emergence of China and India as significant manufacturing players has contributed to the declining availability of industrial metals, such as steel, for the rest of the world.

Types of Commodities

Today, tradable commodities fall into the following four categories:

  • Metals (such as gold, silver, platinum and copper)
  • Energy (such as crude oil, heating oil, natural gas and gasoline)
  • Livestock and Meat (including lean hogs, pork bellies, live cattle and feeder cattle)
  • Agricultural (including corn, soybeans, wheat, rice, cocoa, coffee, cotton and sugar)

Volatile or bearish stock markets typically find scared investors scrambling to transfer money to precious metals such as gold, which has historically been viewed as a reliable, dependable metal with conveyable value. Precious metals can also be used as a hedge against high inflation or periods of currency devaluation.

Energy plays are also common for commodities. Global economic developments and reduced oil outputs from wells around the world can lead to upward surges in oil prices, as investors weigh and assess limited oil supplies with ever-increasing energy demands. Economic downturns, production changes by the Organization of the Petroleum Exporting Countries (OPEC) and emerging technological advances (such as wind, solar and biofuel) that aim to supplant (or complement) crude oil as an energy purveyor should also be considered.

Grains and other agricultural products have a very active trading market. They can be extremely volatile during summer months or periods of weather transitions. Population growth, combined with limited agricultural supply, can provide opportunities to ride agricultural price increases.

How to Invest in Commodities

Futures

A popular way to invest in commodities is through a futures contract, which is an agreement to buy or sell a specific quantity of a commodity at a set price at a later time. Futures are available on every category of commodity.

Two types of investors participate in the futures markets:

  • commercial or institutional users of the commodities
  • speculators

Manufacturers and service providers use futures as part of their budgeting process to normalize expenses and reduce cash flow-related headaches. These hedgers may use the commodity markets to take a position that will reduce the risk of financial loss due to a change in price. The airline sector is an example of a large industry that must secure massive amounts of fuel at stable prices for planning purposes. Because of this need, airline companies engage in hedging. Via futures contracts, airlines purchase fuel at fixed rates (for a period of time) to avoid the market volatility of crude oil and gasoline, which would make their financial statements more volatile and riskier for investors.

Farming cooperatives also utilize futures. Without futures and hedging, volatility in commodities could cause bankruptcies for businesses that require a relative amount of predictability in managing their expenses.

The second group is made up of speculators who hope to profit from changes in the price of the futures contract. Speculators typically close out their positions before the contract is due and never take actual delivery of the commodity (e.g., grain, oil, etc.) itself.

Getting Into Commodities Futures

Investing in a commodity futures contract will require opening a brokerage account if you do not have a broker that also trades futures. Investors are also required to fill out a form acknowledging an understanding of the risks associated with futures trading.

Each commodity contract requires a different minimum deposit (dependent on the broker) and the value of your account will increase or decrease with the value of the contract. If the value of the contract decreases, you will be subject to a margin call and will be required to place more money into your account to keep the position open. Due to the huge amounts of leverage, small price movements can mean large returns or losses, and a futures account can be wiped out or doubled in a matter of minutes.

Advantages of  Futures trading:

  • It’s a pure play on the underlying commodity
  • Leverage allows for big profits if you are on the right side of the trade
  • Minimum-deposit accounts control full-size contracts that you would normally not be able to afford
  • You can go long or short easily

Disadvantages of  Futures trading:

  • Futures markets can be very volatile and direct investment can be very risky, especially for inexperienced investors.
  • Leverage magnifies both gains and losses
  • A trade can go against you quickly, and you could lose your initial deposit (and more) before you are able to close your position.

Most futures contracts will also have options associated with them. Buying options on futures contracts is similar to putting a deposit on something rather than purchasing it outright; you have the right, but not the obligation, to follow through on the transaction. Therefore, if the price of the contract doesn’t move in the direction you anticipated, you have limited your loss to the cost of the option.

 

Commodity Exchange Traded Funds and Exchange Traded Notes

Exchange traded funds (ETFs) and exchange traded notes (ETNs), which trade like stocks, allow investors to participate in commodity price fluctuations without investing directly in futures contracts.

Commodity ETFs usually track the price of a particular commodity or group of commodities that comprise an index by using futures contracts, although a few investors will back the ETF with the actual commodity held in storage. In 2011, the University of Texas Investment Management Company, which oversees $21 billion in endowment and related assets, famously placed 5% of its portfolio in actual bars of gold bullion that were held in a New York bank vault as a currency play.

ETNs are unsecured debt designed to mimic the price fluctuation of a particular commodity or commodity index, and are backed by the issuer. A special brokerage account is not required to invest in ETFs or ETNs.