What is commodity trading and how to trade commodities?

What are commodities?

A commodity is a raw material or agricultural product that can be bought or sold on the open market.

Commodities can be split into two categories: soft commodities and hard commodities. Soft commodities are typically agricultural products such as cocoa, coffee, sugar, wheat, cotton, and soybeans. Hard commodities are extracted from the earth, such as various precious metals (gold, silver, palladium, iron ore, copper) and energy products (oil, natural gas, uranium).

The price of a commodity, like the price of any other good or product, is determined by supply and demand. However, there are unique factors that can influence the price of various commodities. For example, agricultural products will be heavily affected by weather conditions (drought, heavy rains, and natural disasters).

Other products, such as oil, might see significant price swings due to geopolitical factors, such as a conflict or war occurring in a major oil-producing country. Oil prices are also heavily influenced by the decisions made by OPEC, a cartel consisting of some of the world´s major oil-producing countries.

Commodities often serve as key components in various goods (for example, lithium is used in mobile phone production) and are standardised for quality and quantity, which makes them easier to trade.

What is the commodities market?

A commodities market is the place where buyers and investors meet to buy and sell (hard and soft) commodities.

Commodities are traded on two types of markets:

• The spot commodities market, also referred to as the physical market, is where goods are bought and sold for immediate delivery
• Derivatives commodities markets are centralised exchanges where financial products based on various commodities are traded in the form of futures, forwards, and options contracts.

The major commodity exchanges:

• The Chicago Mercantile Exchange (CME) was founded in 1898 as the Chicago Butter and Egg Board. It evolved over time to become one of the most important financial exchanges globally. Aside from commodities, it also specialises in interest rates, equities, and currency futures contracts. While more than 90% of the volume traded on the CME is done electronically, the exchange still operates trading on an open-outcry basis, where traders on the trading floor call out orders.
• The Tokyo Commodity Exchange (TOCOM) is Japan´s largest and one of Asia´s largest commodity futures exchanges. It was founded in 1984 due to a merger. TOCOM offers futures contracts for various products, from precious metals and oil to soft commodities.
• The London Metal Exchange (LME) is the most important futures exchange for metal products. It offers financial derivatives for aluminium, copper, zinc, nickel, lead, tin, and more. While most of the trading is done electronically, it is the only exchange in Europe that still uses a physical trading floor where open outcry trading occurs.
• The New York Mercantile Exchange (NYMEX) is a major futures exchange based in New York City and owned by the CME Group. It specialises in energy products such as coal, electricity, crude oil, heating oil, natural gas, and propane.

What is commodity trading?

When you trade a commodity, you are speculating on the price change of a raw physical asset, like gold or oil. Many factors, especially supply and demand, will impact the market price.

Understanding the market players and their goals is the first step in comprehending what commodities trading is.

There are millions of traders and corporations taking part in commodities trading worldwide with various goals, but we can split them into two broad categories: Hedgers and speculators.

1. Hedgers

A hedger is an individual or company that trades in the physical and derivatives markets. Most hedgers are commodity producers, wholesalers, and retailers of manufactured goods. They all have one thing in common: they are affected by fluctuations in commodity prices.

To mitigate this risk, they use financial derivatives such as futures. Their goal is not to profit from speculation but rather to avoid a negative consequence caused by price volatility in the commodities they deal with.

Imagine a farmer who is storing a quantity of corn, due to a large harvest. By the time he sells it, the price of corn might increase or decrease. To protect himself from those price fluctuations, the farmer can sell corn on the futures exchange. If prices go down, he will earn less from the sale of his physical corn, but the profit he makes from his position in the futures market will offset that. If prices go up, his futures position will cause a loss, but he will earn more from the sales of the physical corn.

As a result, hedgers do not actively look to profit from the futures market. Instead, they aim to safeguard themselves against adverse price changes.

2. Speculators

Speculators are a vast category that includes everything from retail traders managing their savings to multibillion-dollar hedge funds. They all have the same goal: to make money by predicting price fluctuations. Speculators are significant market participants because their operations increase liquidity and improve market efficiency.

What causes the price of commodities to change?

• Supply and demand: The fundamental rule of the market is that as demand rises, so will commodity prices. This is related to income and population, commodity production costs, and the actions of governments and producer organisations.
• Commodity production: The production of commodities is influenced by natural factors like weather and crop conditions, cultivation land, trade constraints, subsidies, taxes, and production-related factors like labour patterns and the development of farming tools and technologies.
• Cost of production: Commodity production costs include raw materials, labour, research and development, insurance, licencing fees, taxes, and much more. An increase in production costs will directly impact the price of the commodity being produced.
• Economic growth: The prosperity of a country indicates the purchasing power of its population. This effect is more obvious in countries that are major producers or consumers. As the economy grows and urbanises, people typically consume more commodities.

How does commodity trading work?

Commodity trading takes place through what is known as a contract for difference (CFD). A CFD trade is simply an agreement between the buyer and seller to complete a transaction at a set price and time.

CFDs do not give you ownership of the underlying asset (for example, a bar of gold). Instead, you trade a “futures contract” that is based on the underlying asset’s real-time price changes. As a result, if the purchasing price of gold rises, so will the traded price.

A trader opens a ‘buy’ position if they think the price will rise or a ‘sell’ position if they think prices will drop.

What is the difference between commodity cash CFDs, futures CFDs, and spot CFDs?

The main difference between trading cash, futures, and spot commodity CFDs is the pricing model.

• Commodity cash CFDs: A cash commodity is a tangible product that is delivered in exchange for payment. The contract for a cash commodity specifies the exact amount of the commodity to be delivered, the delivery date, and the price. Companies speculate on a specific price for a commodity they plan to use, then enter into contracts for cash commodities.
• Commodity futures CFDs: The futures price of a commodity sets a predefined price for a future transaction. This "futures price" is based on the current spot price of the commodity plus the cost of storage or transportation for the period prior to delivery. Interest, insurance, and other incidental charges are all included in the cost of storage or transport.
• Commodity spot CFDs: The spot price of a commodity is the current quote for the immediate (on-the-spot) purchase, payment, and delivery of that commodity

Why trade commodities?

Investors and traders trade commodities for distinct reasons. Some are attracted to the high volatility of certain commodities, which can lead to higher returns. However, the potential for higher returns always comes with higher risk.

Other market participants see commodities as a hedge against inflation. Gold is among the most popular instruments that investors use to protect themselves against rising inflation.

Commodities can also help with diversification. Investors who are mostly exposed to stocks and bonds might want to add commodities to their portfolios to reduce their exposure to only two asset classes. Traders might consider adding oil, gold, or copper to their list of trading instruments to expand their horizons or test their strategy on different instruments. This can be useful if the main asset class they are trading is experiencing low volatility or a market environment that is averse to their trading strategy.

How to trade commodities

The commodities market is accessible to anyone with an internet connection and a computer or smartphone, and it is possible to get started even with limited funds. Here is a quick, step-by-step guide on how to trade commodities using CFDs:

1. Choose a reputable broker: Look for a broker that is regulated, has a good reputation in the market, and offers the full range of commodities you want to trade.
2. Open a trading account: Once you have chosen your broker, you will need to open a trading account. This should be a simple and free process. Note that a reputable broker will require you to verify your ID as part of security and fraud protection.
3. Fund your account: Once your account is verified, you will need to deposit funds in order to start trading. Most brokers accept deposits in common currencies, including USD, EUR, and GBP.
4. Choose a commodity CFD to trade: Select the commodity you want to trade. Popular instruments include oil, gold, copper, and natural gas.
5. Figure out your trading strategy: This involves deciding how much you want to invest, setting stop-loss and take-profit orders, and determining your risk tolerance. You should also consider how much you are prepared to lose if a trade goes against you.
6. Place your trade: This involves selecting the amount you want to invest, choosing the direction of the trade (buy or sell), and setting your stop-loss and take-profit orders.
7. Monitor your trade: Once you have opened a trade, keep a close eye on how it is performing so you can limit losses and protect profits.

If you are new to commodities trading, it is vital that you educate yourself on how the market works and the risks involved. You should also consider beginning your investment journey with a modest amount of money that you are willing to lose if the trade goes against you.

What are the advantages of trading commodities?

Commodities are among the world's top-traded products. Here is why:

• Liquidity: The large derivatives market for commodities, consisting of market makers, speculators, hedgers, and corporations, makes it a highly liquid market. This means that traders can easily buy and sell, i.e., get in and out of their positions when they wish to do so. It also means the market is more open and transparent, that the cost of trading the instrument is cheaper than in illiquid markets, and that it cannot be easily manipulated.
  
  Some commodities are more liquid than others. For example, gold and oil are among the most traded instruments worldwide. On the other hand, commodities like corn and soybeans are less liquid, and price movements could be more erratic.
• Low margin: The margin deposit needed to start futures trading can be as low as 5-10% of the total value of the contract. A lower margin requirement allows traders to control larger positions with less capital being used as margin.
• Hedging capabilities: Participants in the market who are exposed to physical commodities may seek to mitigate their risk by trading in the derivatives market. Rather than looking to profit from their positions, their goal is to protect themselves from adverse price swings.
• Portfolio diversification: Investors who feel overexposed to a certain asset class, such as stocks can choose investments in the commodities space to diversify their portfolio. This can be done through:

1. Exchange Traded Funds (ETFs) based on gold, oil, or any other commodity
2. Futures positions based on gold, oil, or any other commodity
3. Shares of a commodity-producing company (either a specialised one, such as a major gold mining company, or a widely diversified producer)
4. CFD positions based on a commodity futures contract

• Protection against inflation: Commodity prices tend to increase during times of high inflation. Gold is one of the most famous inflation hedges, and investor demand tends to spike when inflation is on the rise.

What are the risks of trading commodities?

• Volatility: Commodities are volatile products. Volatility can lead to more trading opportunities but also greater risk.
• Surprise events: There is often no warning of major events (such as geopolitical instability or natural disasters) that can affect the price of a commodity, catching traders off guard. While this risk cannot be completely avoided, traders can use stop-loss orders to limit their losses.
• Market inexperience: Beginners in commodities trading should research the available products, their characteristics, and the factors that influence their price. They may find it more beneficial to begin trading highly liquid products, such as gold or oil. Less liquid products, such as sugar or soybeans, tend to have irregular price swings and less information available.

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This information is not to be construed as a recommendation; or an offer to buy or sell; or the solicitation of an offer to buy or sell any security, financial product, or instrument; or to participate in any trading strategy. It has been prepared without taking your objectives, financial situation, or needs into account. Any references to past performance and forecasts are not reliable indicators of future results. Axi makes no representation and assumes no liability regarding the accuracy and completeness of the content in this publication. Readers should seek their own advice.