There are many different asset classes traded around the world, including currencies, stocks, stock indices, bonds, commodities and crypto. In this blog we will outline the structure of the global commodities market and explain how traders can use it to diversify their portfolios and capitalize on market movements.
What are Commodities?
Commodities refer to raw materials or agricultural products that are traded in bulk on commodities exchanges. These include natural resources such as crude oil, gold, silver, corn, wheat, coffee and more. Commodities are traded globally, with prices influenced by factors such as supply and demand dynamics, geopolitical events, weather patterns, and even macroeconomic indicators.
Types of Commodities
Commodities can be broadly categorized into four main groups:
- Energy: The most-traded energy commodity is crude oil (either WTI and Brent Crude), but this sector also includes natural gas, heating oil, gasoline and coal.
- Metals: Includes both precious metals (gold, silver, platinum, palladium) and base metals (copper, tin, aluminium, etc.). These commodities play a crucial role in construction, manufacturing and electronics as well as in the jewellery industry.
- Agricultural Products: These commodities are grown to feed (and clothe) the world, such as wheat, corn, soybeans, coffee, sugar, cocoa and cotton.
- Livestock: These include all living agricultural commodities, such as cattle, hogs, pork bellies and poultry.
Each type of commodity has its own unique supply and demand drivers, as well as other specific factors that impact its price movement.
What is Commodity Trading?
Commodity trading involves buying and selling commodities with the aim of making a profit. In some cases, commodity trading may involve the physical delivery or settlement of the underlying asset. However, many traders use derivatives such as futures and options or even CFDs or spread-betting accounts to speculate on price movements without needing to own the underlying asset.
Why Do People Trade Commodities?
There are a range of reasons that individuals and companies trade commodities, but some of the key drivers include:
- Hedging: Imagine a farmer fearing a fall in wheat prices. By selling wheat futures contracts before their harvest, they can lock in a guaranteed price for their produce ahead of time, protecting themselves from a potential fall in the wheat price. However, if wheat prices continue to rise, then the farmer will have lost out on some potential profit, since it would’ve been better to simply harvest the wheat and sell it on the open market.
- Speculation: For many individuals and corporations, the allure of predicting market movements and profiting from price fluctuations is the primary motivator. Speculative trading involves analysis of the market and taking calculated risks in pursuit of potential gains. This analysis may involve looking at the physical fundamentals (such as weather or wars which can affect supply and demand of commodities) or technical analysis and the study of charts to predict potential future price movements.
- Portfolio Diversification: Generally used by longer-term investors, spreading investments across different asset classes, including commodities, can help mitigate risk and potentially enhance overall portfolio returns.
How to Trade Commodities
There are several different ways to trade commodities:
- CFDs and Spread-Betting: For retail traders, the quickest and easiest way to trade commodities is via leveraged retail trading platforms, mostly used for speculation.
- Futures Contracts: These agreements bind buyers and sellers to a specific price and delivery date for a given commodity. Trading companies use futures for speculation, while commodity producers generally use futures for hedging.
- Options: Offering flexibility and controlled risk, options grant the right, but not the obligation, to buy or sell a commodity at a certain price by a certain date. Understanding options strategies enables traders to speculate or hedge their positions to account for different market scenarios.
- Exchange-Traded Funds (ETFs): These are convenient investment vehicles which bundle multiple commodities or derivatives into a single tradable unit. ETFs offer broad exposure to specific sectors or diversified portfolios, allowing diversification without directly managing individual contracts.
Where to Start
If you want to speculate in commodity trading, this can be done through spread-betting, CFDs or futures and options markets. For most retail investors, leveraged trading via spread-betting accounts is the most efficient channel, but there are a few things to consider before starting:
- Education: Before committing real money to the markets, you should spend time to understand the commodities markets. This includes understanding what makes prices move, technical or fundamental trading strategies, and risk management techniques. Resources such as the London Academy of Trading offer courses and resources tailored to aspiring commodity traders.
- Choose a Market: Different commodities are affected by different fundamentals. Some are relatively calm, while others can be extremely volatile, so you should choose the commodities that fit your knowledge, research and risk appetite.
- Select a Trading Platform: Work out whether futures, CFDs or spread betting will best suit your needs and then sign up with a reputable brokerage or trading platform that offers access to the commodities markets you want to trade.
- Analysis: Before trading, you need to work out which direction you expect the price to move. This can be achieved using technical and/or fundamental analysis to identify trading opportunities and develop a trading plan. It may take many weeks and plenty of practice trading on a demo account before you find a consistent and structured trading process.
- Execution: All trades should be executed according to your trading plan, not based on emotional responses such as FOMO. Trade execution should be structured to take into account factors such as stop losses, achievable targets, position size and risk management.
- Practice Makes Perfect: Hone your trading skills through paper trading simulations before deploying real capital. This allows you to test strategies and gain confidence in a risk-free environment.
- Start Small and Scale Gradually: Begin with smaller positions and gradually scale up as your knowledge and experience grow. Remember, discipline and a structured approach are key to long-term success.
- Monitor and Adjust: Continuously monitor your trading performance and use this data to adjust your strategy as required to ensure you maintain an edge in your trading.
Understanding the Risks: A Word of Caution
Commodities trading, while potentially lucrative, is not without its challenges. Price volatility, geopolitical factors and weather events can all impact markets significantly and often without warning. It's crucial to approach commodity trading with:
- Realistic Expectations: You need to understand that consistent profits are not guaranteed and accepting the inherent risks is essential when trading volatile commodities.
- Thorough Research: Before venturing into any market, research is paramount. Analyse market trends, understand the factors influencing individual commodities, and develop a structured and robust trading strategy before risking money in the market.
- Risk Management: An essential part of trading is limiting risk. Always implement a structured risk management strategy, limiting your risk on a per-trade, daily, weekly and monthly basis. Set stop-losses for every trade and make sure to stay within your risk parameters AT ALL TIMES, no matter how good or bad you’re feeling.
Commodities Trading: A Path to Potential
While trading commodities demands diligence and careful risk management, it can also be a rewarding experience. For those with the right knowledge, skills and temperament, commodities trading offers the potential for:
- Financial Growth: Successful traders can capitalize on market movements and generate significant returns.
- Portfolio Diversification: Adding commodities to your investment portfolio can enhance risk-adjusted returns and protect against inflation.
- Intellectual Challenge: Analysing complex market dynamics and developing effective trading strategies can be intellectually stimulating and rewarding.
Conclusion
Commodities trading offers investors a unique opportunity to diversify their portfolios and profit from the fluctuations in global commodity prices. Whether you're interested in energy, metals, agriculture, or livestock, there are plenty of opportunities to explore in commodities markets. By understanding the fundamentals of commodities trading, conducting thorough research, and employing sound trading strategies, you can navigate the complexities of the market and potentially achieve success as a commodities trader. Whether you're a seasoned investor or just starting out, continuous education and practice are vital to master the art of commodities trading.
London Academy of Trading
Remember, trading commodities involves substantial risk and is not suitable for everyone. It's important to do your due diligence and seek professional advice if needed before engaging in commodities trading.
