What is commodity trading: A beginner’s guide

So, you want to know about commodity trading? Then you are at the right place. Whether you're a fledgling investor or merely curious about alternative asset classes, understanding commodity trading can offer invaluable insights.

Trading commodities on various exchanges has become an increasingly popular investment strategy, affording opportunities for portfolio diversification and potential hedging against inflation.

By delving into the mechanics of commodity markets, the types of commodities available for trade, and the basic strategies employed by traders, I hope to provide you with a robust foundation upon which you can build your understanding and, potentially, your investment portfolio.

Read the following article to grasp the fundamentals of what is commodity trading.

What are commodities?

Commodities are basic goods or raw materials that are traded on exchanges and are the building blocks for more complex products.

These can range from agricultural goods like wheat and coffee to minerals such as gold and silver, to energy resources like oil and natural gas.

Commodities are often standardised and interchangeable with goods of the same type, making them ideal for trading.

They play a critical role in the global economy, often serving as indicators of economic health.

What Is Commodity Trading?

Commodity trading usually involves the buying and selling of raw materials or primary goods, such as metals, energy, and agricultural products, on designated exchanges.

These trades can occur in physical markets, where actual goods are bought and sold, or through financial derivatives like futures contracts, where the parties agree to trade commodities at a future date and at a predetermined price.

The aim of commodity trading is often to profit from price fluctuations. Commodities are unique in that they have both a real-world physical presence and can also be traded as financial instruments.

They play a significant role in the global economy, often serving as indicators of economic health and inflationary trends. Additionally, commodities can offer opportunities for diversification and risk mitigation in an investment portfolio.

Understanding the unique aspects of the commodities market

At its core, the fundamentals of supply and demand dictate the dynamics of the commodities markets. Fluctuations in supply influence demand; a scarcity in supply generally leads to increased prices. Major interruptions in a commodity's supply, like geopolitical tensions or conflicts in oil-producing regions.

For instance, if there's political instability or military conflict in the Middle East, it could lead to the disruption of oil production and transportation, causing a significant reduction in global oil supply.

This shortage would likely result in a spike in oil prices due to the constant demand for energy worldwide.

Likewise, global economic growth and advancements in technology can have an effect on commodity prices.

With the rise of China and India as key players in manufacturing, and their consequent need for more industrial metals, has lessened the availability of metals like steel for the rest of the global market.

Different types of commodities

Commodities can be broadly classified into four major categories, each with its own set of subcategories and unique characteristics.

Understanding these different types can provide valuable insights into how the commodities market operates.

1. Agricultural commodities

These include food crops, livestock, and other products that are grown or raised on farms.

• Grains: Wheat, corn, soybeans, and rice are examples of grain commodities.
• Softs: This subcategory includes commodities like sugar, cocoa, and coffee.
• Livestock: Examples are cattle, hogs, and sometimes poultry.

2. Energy commodities

These commodities are crucial to power the modern world and include various types of fossil fuels as well as renewable sources.

• Crude oil: This is one of the most actively traded commodities globally.
• Natural gas: Typically used for heating and electricity generation.
• Coal: Though it has declined in usage, coal is still a significant energy commodity.
• Renewables: These are newer additions to the market and include ethanol and biofuels.

3. Metals

Metals basically can be divided into two broad categories based on their economic value and utility.

• Precious metals: These include gold, silver, and platinum, which are often used as a store of value or in industrial applications.
• Base metals: Examples are copper, aluminium, and zinc, which are generally used in construction and manufacturing.

4. Environmental commodities

These are market-based instruments aimed at reducing environmental impacts.

• Carbon credits: These permits can be traded and grant the owner the right to release a specified quantity of carbon dioxide.
• Emission reduction credits: These are similar to carbon credits but can include reductions in other types of pollutants.

5. Other commodities

Some commodities don't neatly fit into the above categories but are nonetheless important.

• Fibres: Such as cotton and wool.
• Tropical products: Like rubber and palm oil.
• Spices: Such as pepper and vanilla.

Why do people trade commodities?

Trading commodities can offer a range of benefits to investors, traders, and even businesses involved in the production or consumption of these goods. Here are some compelling reasons why people trade commodities:

1. Diversification

Commodities frequently exhibit low or even negative correlations with other types of investment assets.

This characteristic can serve as a diversification tool, aiding in the reduction of the overall risk profile of an investment portfolio.

2. Hedging

For businesses that rely on certain commodities, trading in futures or options can serve as a hedge against price fluctuations. For example, an airline might hedge against rising fuel costs by purchasing oil futures.

3. Inflation protection

Precious metals such as gold and silver are commonly viewed as safe-haven assets during periods of inflation. When the prices of goods and services escalate, the worth of these commodities usually experiences a corresponding uptick.

4. High liquidity

Major commodities like oil, gold, and agricultural products are traded in large volumes daily, offering high liquidity and ease of entry or exit from the market.

5. Profit potential

The commodities market is known for its volatility, which, although risky, presents opportunities for high returns for well-informed and strategic traders.

How to trade commodities?

One of the most accessible methods for trading commodities is through Contract for Difference (CFD) instruments.

Available on numerous trading platforms, CFDs let investors trade a variety of commodities like oil, gas, and coffee without the need to own the actual asset.

These instruments are flexible, allowing traders to go short and potentially earn profits even if the commodity's price decreases.

Numerous investors keen on participating in a specific commodity market often opt for shares in corporations that have some connection to that particular commodity.

As an illustration, those who want to invest in the oil sector have various options, including shares in oil extraction firms, refining companies, tanker operations, or even conglomerates that are diversified within the oil industry.

For those looking to enter the commodities market, exchange-traded funds (ETFs) and exchange-traded notes (ETNs) serve as alternative investment vehicles.

These financial instruments are traded similarly to stocks and offer the opportunity for investors to benefit from commodity price swings without having to directly engage with futures contracts.

What drives the prices of commodities?

In the commodities market, a variety of factors contribute to the pricing of goods, each influenced by the supply and demand dynamics. Below are some key elements that drive the prices of commodities:

1. Supply and Demand

The most fundamental factor, an imbalance in supply and demand can dramatically influence prices. For instance, if a weather event affects crop yield, supply may decrease, leading to a rise in price given constant demand.

2. Geopolitical Events

Political instability in regions which are key producers of a particular commodity, such as oil, can result in supply disruptions, thereby affecting prices.

3. Currency Fluctuations

Given that a significant number of commodities are quoted in U.S. dollars, fluctuations in the dollar's value can have a direct effect on commodity prices. A weaker dollar typically makes commodities more expensive for buyers in other currencies.

4. Economic Indicators

Various economic metrics like GDP growth, employment data, and interest rates can indicate the health of an economy and, in turn, influence demand for commodities.

Strategies & tips for commodity trading

One of the most common strategies for commodity trading is trend following, where traders aim to capitalise on upward or downward price movements by studying historical data and using various indicators like moving averages.

This can be particularly useful in the commodities market, which is often subject to cyclical trends influenced by factors such as seasonality, geopolitical events, and economic indicators.

Another common strategy or more like a tip is choosing the right broker. Often overlooked in commodity trading is the importance of selecting the right broker. The broker plays a critical role in shaping the advantages you gain from trading commodities.

Issues like a sluggish online platform can delay order execution, while high brokerage fees can eat into your actual profits.

At markets.com you can be assured that you are trading in an environment that is fully secure and regulated, so you can focus on trading the way you want to.

Bottom line

Navigating the world of commodity trading can be complex, but understanding its fundamentals and strategies can open the door to more opportunities.

This beginner's guide serves as a comprehensive starting point to help you make informed decisions as you venture into the commodities market.

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“When considering Commodities for trading and price predictions, remember that trading CFDs involves a significant degree of risk and could result in capital loss. Past performance is not indicative of any future results. This information is provided for informative purposes only and should not be construed to be investment advice.”