Commodities are tradable instruments and raw materials that we use in our everyday lives including livestock, oil, natural gas, and grains. These products offer unique investment opportunities for investors with specialized knowledge of the factors affecting their supply and demand. Trading this asset class is a great way to diversify your portfolio besides trading forex and other financial assets. In this article, we will discuss the details of commodities trading – what it means, how it works, and four simple steps to help you get started. Let’s begin!
A Basic Guide to Commodities
What are Commodities
Commodities are raw materials and assets that are used to produce finished products. As financial assets, they are physical goods that can be traded and interchanged in the financial market. You can analyze their price movements on brokers like https://www.oanda.com to help you make informed investment decisions. Commodities are classified into groups;
- Metals: Some metals are valuable assets that can be traded and exchanged. Metals like zinc, aluminum, and iron ore. Precious metals like gold and silver are also raw materials that can be traded in the commodity market. In times of uncertainty and turmoil, investors tend to invest in gold as a ‘safe haven’ asset. This helps them offset the risks they have incurred by investing in other assets.
- Energy: The renewable (solar, wind) and non-renewable (coal, natural gas, oil) energy products can be traded as financial assets.
- Agricultural Products: Agricultural commodities are grains, cotton, rubber, and edible products like sugar.
4 Ways To Trade Commodities
The forces of supply and demand highly influence commodity prices – If the demand increases, there would be a corresponding increase in price. Changes in the supply chain also affect the prices of these assets. For instance, when agricultural production is hindered by drought or diseases, the prices of agricultural products tend to increase. Industrialization – fueled by the manufacture of machines and production machinery, can lead to an increase in the demand for metals like aluminum and steel, causing their prices to increase due to scarcity. Essentially, if investors have reasons to believe that the price of a commodity will increase, they buy (or go long). If they have reasons to believe that the prices will decline, then they sell (or go short).
Trading Commodities Futures
Futures contracts are legally binding agreements in which two parties agree to trade an asset at a specified date and price. Futures contracts can be used to trade commodities. When the future contract expires, the buyer buys from the seller, who delivers the goods at the agreed price. Upon the contract’s expiration, the buyer doesn’t receive the physical goods but closes the contract by taking an opposite trade in the spot market. If the spot price (current market price) of the commodity turns out higher than the contract’s price, then the buyer makes a profit. To trade futures contracts, you have to be registered on a brokerage platform that offers futures contracts.
Trading Commodity Stocks
Another way to invest in a commodity is to invest in shares of companies that are associated with it. For instance, you can buy shares in a steel manufacturing industry if you believe that steel would increase in value.
Purchasing stocks provides a great trading environment because stocks are highly liquid and accessible on various brokerage platforms. You can invest in stock options if you have limited capital because they require smaller investments.
Trading Commodities with ETFs
You can invest in commodities through exchange-traded funds (ETFs) and notes(ETNs). These help you profit from the price fluctuations, without direct investment in futures contracts. The fund can buy shares or invest in stocks of companies associated with certain commodities. The ETFs portfolio is usually managed by a professional. A drawback associated with this method is that the movement of the ETF or ETN may not reflect the price of the related commodity.
Trading Commodities via Commodity Pools
Investment funds can be pooled and gathered by commodity pool operators(CPOs). Investors provide funds to the CPOs, who invest them in futures and options contracts. The CPO must remain transparent by providing records of transactions and investors. The commodity pools and managed futures are not publicly traded and often use advanced trading strategies to increase the return on investments.
4 Steps to Trading Commodities
- Open a Trading Account: As a retail trader or investor, you can trade commodities, stocks, or futures on a brokerage account. You can use a live or demo account, depending on your level of expertise.
- Choose an Asset: While choosing a product to trade, make sure you learn about the factors that influence its price.
- Decide to Sell or Buy: You can buy or sell based on the results of your analysis and research.
- Manage Your Risk: While trading commodities(or any financial asset), ensure that you manage your risk and use proper risk management strategies.