Commodities Trading And Their Benefits
Commodities trading refer to the resources or raw materials required to manufacture various other refined goods.
Contrary to finished goods, commodities are standardized. This implies that two different units of a commodity that are equal in measure will be identical, regardless of their origin or production and hence they can be use interchangeably. Similar to stock trading, where you trade company shares, in commodity trading, you buy and sell commodity products. This trading is carry out on certain exchanges, and the ultimate aim is to profit from the developments in the commodity market.
Types of commodities
There are plenty of commodities out there. They are put into three major category: agriculture, energy, and metals.
Agricultural commodities include:
- Items you can drink, like sugar, cocoa, coffee, and juice. These are know as “softs markets.”
- Grains like wheat, soybeans, soybean oil, rice, oats, and corn.
- Animals that are farmed/bred for consumption, like live cattle and pork (called “lean hogs”).
- Inedible products that are use widely like cotton and lumber.
Crude oil, RBOB gasoline, natural gas, and heating oil come under the energy segment. Commodities trading plays an important role in deciding oil prices.
Metals cover commodities that are mine like gold, copper, silver, and platinum.
How does the commodities trading market work?
Commodities trading helps in establishing commodity prices. Hence the rates of key items that are use on a daily basis, tend to be volatile. Prices of certain items like gasoline change from day to day.
Commodities trading particularly affects lower-income people around the world, who spend a major part of their limited income on food and transportation. It also makes farming a risky business and is one of the leading reasons why the U.S. government spends so much on farm subsidies.
Oil, gold, and agricultural products are also trade significantly. As transportation of these heavy materials can be tricky, they are trade as futures contracts. These contracts are essentially agreements to buy or sell at a pre-decided rate on a pre-decided date. Commodities contracts are usually price in U.S. dollars. This implies that when the value of dollar strengthens, you have to pay less for the same amount of commodities which causes the commodity prices to fall.
Participants in the commodity market
Speculators and hedgers steer the commodity market. These traders keep a close watch on commodity prices and predict the future price movement. For instance, they may speculate that the rates will increase and hence they buy commodity futures contracts. If they expect a significant rise then they try to sell the contracts at a better rate than what they paid for them. In another scenario, if they expect the rates to fall, they sell the contracts only to buy them again at a lower rate. Their ultimate aim is to make the most of every situation and earn profit.
Producers, manufacturers, etc. typically try to cut down their risk with the help of the commodity futures market. To illustrate this, let’s look at the situation of a wheat farmer. If the rates fluctuate during harvest season and the price falls, the farmer would have a loss.
To minimize losses in such a scenario, the farmer hedges the risk by entering into a futures contract. When prices trip in the local market, the farmer can make up for the loss with the help of the gains in the futures market. But if the prices increase during harvest, the farmer will face the risk of incurring loss in the futures market which can be offset by selling at a higher price in the local market.
Methods of commodity trading
Commodities can be traded using various methods:
Commodities Trading Futures
Commodity trading can be done by buying and selling contracts on the futures exchange. It is essentially a mutual agreement with another investor on the basis of the commodity’s future rates. You must have an account with a specialty brokerage that allows such trades.
Physical Commodity Purchases
Every time you trade futures contracts, you do not have the physical goods like millions of barrels of oil or live cattle in your possession. Rather, you’re simply speculating on the price changes. However, if you’re dealing with precious metals or jewellery, you may own the physical items.
Investors who choose to be a part of the market only for a certain commodity could consider commodity-related stocks as an investment option. Stocks are relatively less volatile than future contracts. Buying, holding, tracking, and trading stocks becomes simpler for traders. Investments can essentially be limit to a certain sector if you please. Investors could buy options on stocks that need minimal investments and you don’t have to buy stock directly.
Benefits of commodity trading
Transparency in trading
Since commodity trading is carried out via an exchange, the prices cannot be manipulated by buyers or sellers. The buyer would quote a price and so would the seller. If they’re aligned, the order gets executed. Thanks to advanced online trading platforms, price discovery of commodities is now possible without worrying about any manipulation. Low margins in commodity futures attract several small trades to invest in this segment to hedge their risk and avail better leverage.
There are a number of factors that can make a difference in the prices of individual commodities. For instance, supply and demand, inflation, and the economy can impact commodity prices. Given the large-scale infrastructure projects that are on globally, the increased demand for the global infrastructure projects affects commodity prices.
Diversified investment portfolio
A diverse investment portfolio is an indicator of an ideal asset allocation plan. Commodities can play an important role in diversifying the investment portfolio. You can choose to invest in raw materials or stocks and bonds.
Cushion in case of market fluctuations
When there is inflation in the market, investors often choose to sell off stocks and bonds to invest in commodities. This gives the prices of commodity goods a solid boost. Commodities can help in hedging against risks associated with market fluctuations.
Traders can choose to deposit 5 to 10% of the overall contract value as a margin with the broker which is remarkably low than other asset classes. Low margins make it feasible for individuals to invest and hold bigger positions with lesser capital.