What is Commodity Trading?
Commodities trading is the buying and selling of different commodities or their derivatives with the aim of making a profit out of their price changes. Commodities are vital for human existence, and have been traded since immemorial.
Traditionally, commodities were traded arbitrary or informally, but nowadays, they are mainly traded with standardised quantities and quality on major centralised global exchanges, such as the Chicago Mercantile Exchange (CME), New York Mercantile Exchange (NYMEX), Intercontinental Exchange (ICE), and the London Metal Exchange (LME).
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What is a Commodity?
There are mainly three types of commodities commonly traded (categorised according to their utility): metals, energy, and agriculture.
Metals are hard commodities (mined from the ground) that are typically used in construction. Some metals, such as gold, also hold aesthetic value and are used for investment purposes as well as jewellery. Precious metals are also sometimes used by investors as a hedge against inflation.
Energy commodities are also classified as hard commodities, and they are used to generate energy that powers the global economy. Energy commodities include oil and natural gas, and they are used to power factories, facilitate the transportation of goods, and even heat our homes.
Agricultural commodities are classified as soft commodities (grown and harvested or reared above the ground), and they are typically used as human food, with some having some industrial uses. Agricultural commodities include sugar, cotton, and wheat. Livestock and meat products, such as pork bellies and live cattle, can also be classified under agricultural commodities.
What is a Commodity Market?
Commodities are primarily traded in 4 markets: spot, futures, options, and forwards. On the spot market, commodities are traded or exchanged using the live current price rates. A popular way of trading in the spot market is using commodity CFDs (Contracts for Difference).
On the commodity futures market, a contract holder has the right to buy or sell a set amount of the underlying commodity at a set price on a set date in the future.
In commodity options trading, commodities are traded in the same manner as in the futures market, but a contract holder has a right, but not an obligation, to exercise it.
In the forwards market, contracts are generally private and customised between parties, and the trade is conducted Over-the-Counter (OTC).
Apart from the spot commodities market, the other markets focus on the future prices of an underlying commodity. The curve of future prices can either be rising or falling or, in other words, experience contango or backwardation. In a contango pattern, commodity prices are expected to rise in the future (higher than current spot prices); whereas in a backwardation pattern, prices of an underlying commodity are expected to fall in the future (lower than current spot prices).
How to Trade Commodities
To trade commodities effectively, it is important to first understand what influences their price changes. Here are some of the factors that impact the supply and demand of commodities:
- Global Economic Conditions – As essential human products, commodities tend to be sensitive to changes in global economic conditions. Their demand tends to grow during periods of economic boom while slumping during periods of economic uncertainties.
- Consumer Trends – Commodities are utilised by consumers, and their changing tastes and preferences can impact their demand and consequently influence their prices. For instance, the growing demand for electric vehicles can lead to more demand for metals such as lithium and cobalt, while simultaneously decreasing the demand for oil.
- USD Strength – Prices of commodities in the international markets are denominated in US dollars (USD). This has created an inverse correlation between the strength of the USD and commodity prices. When the US dollar value strengthens, commodity prices tend to fall, and vice versa.
- Politics – Political policies and events directly impact commodity trading in the international markets. For instance, in the oil market, OPEC is a major intergovernmental organisation that can influence oil prices by institution production cuts or boosts by their members. Geopolitical events, such as military conflicts, import/export taxation, and trade wars, can significantly impact the demand and supply of various commodities.
- Weather – Weather conditions particularly have a massive influence on the production of agricultural goods. Extreme weather conditions, such as floods, hurricanes, and other natural disasters, can impact the production and transportation of agricultural commodities and directly impact their prices. Forecasts of exceptionally warm or cold winter season can impact the demand for energy commodities as well.
Prices of commodities are influenced by diverse factors, and traders must incorporate an effective risk management plan in order to trade them effectively. Traders typically hedge spot positions by opening alternative trades in futures, options, or forwards markets. For instance, if you have bought gold in the spot market, you can hedge that position by buying a put option contract that will be in profit when prices fall.
Build Your Commodities Trading Strategy
Commodities are excellent assets to trade. They feature great bullish and bearish price cycles and provide numerous lucrative opportunities for both short-term and long-term strategies. Commodities also serve as good hedges against inflation as well as practical diversifiers of portfolios composed of assets, such as stocks and bonds.
When building a commodity trading strategy, it is important to evaluate both fundamental and technical aspects of the underlying asset. Fundamental analysis involves investigating supply and demand factors so as to establish the intrinsic value of a commodity. For instance, a wheat trader should be able to track factors such as oil prices, weather, demand from importing countries, production statistics from exporting nations, as well as government taxes and policies.
On the other hand, technical analysis involves predicting future prices based on the past price action of an underlying commodity. For instance, an oil trader can use mathematical indicators, such as trendlines and Fibonacci tools, to establish short-term trends or potential trend reversals in the market.
Advantages of Trading Commodity CFDs
One of the relatively easy and low-cost ways to trade commodities is via the CFDs market. When trading CFDs, you do not own the underlying commodity, but you only speculate on its price changes. Here are some of the advantages of trading commodity CFDs:
- Leveraged Trading – CFDs are leveraged products, allowing you to boost your overall trading capital. With leverage, you can also make bigger profits out of small price changes in the market, but keep in mind that leverage increases your risks by the same multiplier.
- Buy or Sell Without Restrictions – Go long or go short according to market conditions.
- Risk Management Tools – Use limit orders and conditional orders, such as stop loss and take profit, to manage your risks in the CFD market. You can also perform hedging strategies without any restrictions.
- High Liquidity – A CFD contract is between you and your broker, which ensures that there will almost always be sufficient liquidity.
- Low Trading Costs – CFDs trades only have spread fees, which can be as low as 0.01% of your overall position.
Final Words
Commodities are great financial assets to trade. Open a free demo or live account and explore opportunities in the commodities market with AvaTrade. AvaTrade is a highly regulated CFD commodity broker that features advanced trading platforms that give you access to various commodities, as well as other financial asset classes such as stocks, forex, cryptocurrencies, ETFs, bonds, and options.
Open a Demo account to practice what you’ve learned or a Real account to start trading today!
FAQ
- What are the 3 types of commodities?
The three types of commodities are energy, metals, and agriculture.
- Is commodity trading profitable?
It can be profitable, however, commodity prices are very volatile. This volatility provides plenty of potentially profitable trading opportunities, while also being the main source of market risks.
- How do I start commodity trading?
Open a demo or live AvaTrade account. Choose from the catalogue of commodities available to trade and decide whether to go long or go short.
