Social Media Snippet: Wanted to trade #commodities but never known where to start? We get you started with our guide to #CommodityTrading.
Commodity trading is one of the earliest types of trading to exist. Trading commodities can be dated as far back as 4500 BCE in Sumer – the city we now call Iraq – where a commodity market exchanged clay tokens for goats.
Commodity trading even helped establish successful historical empires who were found to have implemented trading systems to facilitate the trading and exchange of commodities.
Then in 1848 the Chicago Board of Trade was initialised, and commodity trading became one of the most popular markets to trade on – just like today.
In this blog, we’ll define what commodities are and tell you how you can start trading them.
What are trading commodities?
The definition of a commodity is a type of good, or raw material, that can be sold in commerce. Commodities come in two categories: Hard commodities and soft commodities.
Hard commodities refer to natural resources that require mining or extraction, like gold. Soft commodities on the other hand refer to commodities that are used as part of a more comprehensive good or service. For example, corn and wheat are soft commodities that can be used in the production of cereals.
What differentiates commodities from other tradable goods is their ability to be both interchangeable and also standardised. That means that the trade value of a commodity does not fluctuate. No matter where a commodity is produced in the world, the units will usually have the same quality and therefore the same price, with some small exceptions. For example, 500 grams of cocoa beans will still retain the same value whether they are produced in Ghana, the Ivory Coast, or Nigeria.
At Alphachain Academy, we regularly stress the importance of monitoring news events to our traders. This is because a world event will have a knock on effect onto the markets, and commodities are no different.
Supply and demand are the basic principles that drive the commodities markets, and are therefore easily impacted by world events. A change in supply will impact the demand, and low supply almost always equals higher prices.
This can work to a traders advantage because with experience it can become easy to predict a spike in demand. An easy example is that of livestock. A health issue, such as foot and mouth disease, will almost always result in a profitable spike in demand.
Increasingly, more and more commodities traders are adopting algorithms to enter and exit their trades. Read more about Algorithmic Trading in our guide.
What are the types of commodities?
Though there are two categories of commodities, there are actually four types which fall under these categories. Agriculture and livestock are soft commodities, whereas energy and metals are classed as hard commodities.
In more detail, the four types of commodities are:
Agricultural commodities includes goods like:
Agricultural commodities like grains are particularly volatile throughout the summer months, or in any period where there is either a seasonal transition or significant weather event: I.e, winter to spring, or a hurricane or storm.
As the world’s population grows, agricultural supply is becoming limited, which is driving higher prices, so agricultural commodities have become a profitable opportunity for traders.
Energy commodities include energy sources such as:
- Crude oil
- Heating oil
- Natural gas
Just like agricultural commodities, the demand for energy sources and energy related products has soared due to the dwindling of available oil supplies, which has led to rising energy commodity prices.
However, unlike the profitable agricultural supply and demand, traders entering the energy sector of the commodities market must be aware of global events and subsequent economic downturns.
Recently the global pledge to lower carbon emissions has meant that alternative energy sources such as solar power and wind energy are beginning to replace primary energy sources like crude oil. This advancement ultimately has a huge impact on the market prices of the commodities – and it’s not always in a traders favour.
Staying aware of news events is vital for traders, and it’s why at Alphachain Academy we provide a Squawk Twitter service to all our traders. Never associated Twitter with trading? Find out why it’s so vital.
Livestock commodities include a range of live animals such as:
- Live cattle
- Feeder cattle
- Pork bellies
- Lean hogs
Livestock are relatively stable commodities because their demand is often steady, unless there is a significant event, like the threat of disease.
Metal commodities include metals that must be mined and/or extracted such as:
In times where the market is either particularly volatile, or there is high inflation or currency devaluation, some traders invest in metal commodities like silver and gold because they are both seen as reliable, dependable metals which have high conveyable value.
Gold is particularly referred to as a “safe haven asset”, but silver also has advantages in that its price moves faster than the price of gold, making it an attractive proposition for commodity traders.
What are the advantages of trading commodities?
There are a multitude of reasons to trade commodities, and they make for both profitable and reliable investments.
The three main advantages of commodity trading are:
- Portfolio Diversification
Commodities have a low correlation to stocks, which makes them a fantastic way to diversify a trader or investors portfolio.
For example, if the price of oil increases, the price of petrol will increase, which has a knock on effect to car owners whose overall car costs increase. This results in declining car sales, especially if this is coupled by a period of financial uncertainty. The overall effect of this is felt in the stock market, because the price of auto stocks fall.
Hence, portfolio diversification. If the surging price of commodities drives the stock price down, the losses a trader incurs in the stocks can be balanced by the gains made in a commodity derivative.
- Hedging against inflation
As the demand for a product or service increases, so does the price because the cost of the raw material (the commodity) also increases.
A knock on effect of this is then felt in interest rates, which also increases the cost of borrowing and at the same time reduces the net income of the trading firm or company. Declines in gross income then has further reaching consequences into the profits shared between shareholders.
The ultimate result of this is that in an inflationary period, the prices of stocks fall, but the price of commodities rise due to growing demand.
Hence, investors and traders use commodity trades as a way of protecting their capital from inflation and retaining their profits and value.
- High leverage opportunities
Certain commodity derivatives such as futures and options give traders the opportunity to possess a high degree of leverage. Traders can potentially control a big position whilst only paying around 5-10% of the total contract value as an upfront margin.
Therefore, insignificant moves in the prices of commodities can suddenly result in substantial gains should a commodity experience a sudden spike in supply and demand. For example, if livestock is under threat of a disease, the supply and demand of cattle is likely to suddenly spike.
The minimum margin required for commodity futures does vary, but ultimately is still more cost-effective than stocks.
How to start trading commodities?
There are a number of different ways in which to trade commodities. Below we’ve outlined the most popular options.
- Invest in physical commodities
Whilst the majority of commodity trading is now done online, there is still an option to purchase commodities directly at their source, e.g from farmers or oil companies. This is a manual process, because over time an investor would need to then locate a buyer and complete any sales and storage themselves.
- Trade commodity futures
Futures are a type of trading derivative where a seller will agree to sell a set quantity of a particular commodity at a set price to a buyer on an agreed date in the future.
A main benefit of trading commodity futures is their use of leverage which allows traders to make larger trades than they may be able to initially purchase outright. For example if a futures contract has a leverage of 1:10, it means that for each dollar, pound or euro the trader is willing to invest, they will access $10, £10 or €10 of the particular commodity.
This can significantly boost trading profits, but can also work against a trader to amplify trading losses.
Leverage is what makes futures trading particularly attractive to new traders, but trades should always be assessed, evaluated and analysed as futures trading is complex and there a number of factors to take into account when predicting the market direction.
For example the cost of storage and interest rates must also be assessed alongside the initial price of a commodity to evaluate how it may influence the overall commodity price.
- Trade commodity options
Similar to futures, options are another type of trading derivative that allows traders to trade on the changing price of a commodity without needing to purchase the commodity in its entirety.
In options trading there are two types of options contracts: Calls and puts.
In a call option, the owner has a non-obligated right to buy a commodity future contract at a set price before a certain date. In a put option, the owner has a non-obligated right to sell a futures contract at a set price before a certain date.
If the price of a future contract becomes higher than the agreed price, the call option will be sold for profit. For a put option, it’s the reverse. The price must fall below the agreed price before it can be sold.
Option traders must therefore consider how market pricing will change their strategy, and also be aware of the timings of any change taking place.
- Trade commodity CFDs
CFDs, or Contracts for Difference, are another type of trading derivative used to trade commodities.
Like futures and options, CFDs also allow traders to evaluate the changing prices of commodities without necessarily needing to own the commodity in its entirety.
A CFD is therefore a contract between two parties: A trader and a broker. At the end of the contract, the two parties will exchange the difference between the price of the commodity when they entered into the agreement, and the price of the commodity at the close of the agreement.
For example if a trader opted to go long on a CFD trade on gold, and the price at the entrance of the trade was $1,500, but upon the close of the contract the price had risen to $1,525 the trader would make a profit of $25. If the price of gold was to fall at the end of the agreement, the trader would make a loss of $25.
Put simply, in a CFD, a trader only pays the difference between the opening and closing prices of the commodity that is being traded.
Trading commodities gives traders diversification in their trading portfolios and also provides good risk management if a trader is trading both stocks, and commodities. There are many different ways to begin commodity trading, and commodity trading is all but straightforward providing traders are monitoring live news events and evaluating the impacts of these.
The next stage in beginning to trade commodities is finding a reliable trading firm. At Alphachain Academy, we trade over 100 markets in four asset classes: Commodities, FX, Cryptocurrencies and stock indices. What’s more, your personal risk is mitigated because you use our money to make you money.