What Is Commodities Trading?
Commodity markets usually influence close to every aspect of our everyday life.
From the gas station to the supermarket, to the energy equipment we use to cool and heat our homes, commodity prices continue impacting the world economy on almost all levels. In financial markets, however, commodities could be used as speculative tools or as ways to diversify your broader investment portfolio. Each day, billions of dollars make their way in and out of the commodities market, cementing its position as one of the most crucial asset classes across the globe.
What’s a Commodity?
A commodity could be simply defined as the primary material used as an input in the production of refined goods.
Commodities are usually interchangeable with other similar materials. For instance, Brent crude oil from the Arctic is the same material and could be used for a similar purpose as the Brent crude oil from Asia.
Although there could be quality differences when one is comparing commodities from multiple sources, the materials themselves are usually largely uniform although they could originate from multiple producers.
When a commodity is traded on exchange platforms, it should meet specific minimum elemental and quality standards. These minimum standards are often called the basis grade.
How Commodities Are Traded
Commodities could be traded in both future markets and spot markets. Spot markets are often associated with real-time prices. For instance, spot diamond prices could show current as $800 per ounce. This basically implies that diamond for instant delivery could be sold or bought at that price (similar to a jewelry store). Typically, spot markets are used by producers and businesses that intend to use the materials in question. It is for this reason that they are always ready to pay the spot prices which are immediately valid.
As an alternative, commodities could also be traded in future markets, which are often used by investors and speculators. In this case, the commodities themselves are not what is actually being traded. Instead, investors usually deal with contracts to sell or purchase the product sometime in the future. These contracts typically outline a specific time and price that will be used to complete a transaction at a later date. Often, there is usually no specific delivery of the physical item since the speculators and investors will quickly roll over their current positions or just close them early so as to capture the untapped profits on their current positions.
When a commodity is traded using a future contract, there is a more significant potential for more substantial fluctuations and volatility of prices. This is due to the fact that it is not easy to get an accurate sense of the actual position the market prices should hold, say a month or year to come.
When an environmental change is experienced, speculative investors begin to adjust their positions, and this usually has an impact on the demand and supply dynamics that eventually determine the price. This is the manner in which volatility is generated, so you should always bear this in mind while assessing whether to trade commodities through future markets or spot markets.
How Can You Profit From Commodities Trading?
In the typical investment market, speculators are always looking to purchase an asset at the lowest price and sell it at the highest price. This is also the case for those dealing with commodities trading. However, it is essential to bear in mind that the commodities market is typically characterised by significant levels of leverage. Besides, positioning usually is done through contract sizes instead of individual shares, as it happens in stock markets. This could easily amplify the potential for losses and gains, so trading in commodities markets needs a conservative outlook to protect your trading account from any negative surprises.
Commodities markets usually operate 24 hours daily, all days of the week. This offers a greater level of flexibility for anyone who might not be in a position to trade actively during regular hours seen in stock exchanges. For those who are looking to explore a market with oil, precious metals, or grains, commodities market provide easy access with minimal trading costs. In fact, some of the world’s renowned traders focus entirely on commodities, so if you possess some knowledge in these fields, there are good opportunities to enjoy long-term success. It is, however, vital that you do not jump into live positions too fast.
You need to take your time, gather all the necessary information about the forces responsible for moving market prices and begin trading with a demo account which lets you gain familiarity with the manner in which traders place their real-time market orders. This is the easiest way to avoid unnecessary mistakes which could easily debilitate your trading account and make it extremely difficult for you to gain your traction even before you can actually begin.
Is Commodities Trading Ideal For You?
The modern financial markets usually give numerous choices for new investors. Currencies, bonds, stocks, and options are all viable tools for anyone looking to express a new market view and leverage on any potential trends as they continue to develop. However, there are some advantages which are usually associated with the commodities space and which should be considered by anyone who wants to tap new opportunities in the market.
More specifically, adding commodities to diversify your investment portfolio could aid in enhancing your returns while reducing the overall risk levels. There are many reasons why people choose to venture into commodities trading, and they will help you decide whether or not commodities trading is ideal for your personal investment goals and style.
1. A Hedge Against Inflation
One of the main reasons why people opt for commodities trading is that it offers a reliable hedge against the effects of inflation. With time, currencies depreciate and this, is probably why you should never keep all your holdings in cash for a long time. Currency depreciation is another term for inflation, and it is a long-term characteristic for most of the world’s economies.
When depreciation occurs, it usually affects the currency and not the assets which are priced in the currency. And when investors are largely exposed to commodities in times of inflation, the value of their investment usually goes up while the market continues to suffer. For these reasons, commodities typically provide an excellent alternative in the market when there is a buildup of inflationary pressures.
2. Immune To Stock Collapses
Another reason why you should consider commodities trading is that it could offer protection against collapses seen in the current stock market. Stock markets often work in cycles; the broad economic optimism results in asset bubbles, and when the bubbles burst, a collapse follows. There have been such incidences in the past, and you should not expect this trend to end as we move forward. An investor can protect himself from the adverse effects of a stock market collapse when he used commodities as an alternative tool to allocate resources.
The cyclical characteristics in most periodical commodities trends are usually less drastic when you consider the price action from the long-term perspective. This implies that the probability of risk is greatly minimised when an investor is exposed to the commodities market. It is certain that traditional stock investing is the most popular asset selection for an individual investor. But when you take a closer look at the factors mentioned earlier, it becomes evident that a stocks-only approach only creates more risks that are unnecessary. Most of these risks, however, could be minimised by adding commodities investments to a broader strategy.
The Risks of Commodities Trading
When you are just getting started with commodities trading markets, you could be easily distracted by the notion that it is an opportunity for quick cash. You should, however, bear in mind that successful trading in a financial market should not be a gamble and a good evaluation of the risks associated should be done before placing any real money trades. Traders should view commodities trading as a business, and when they do not adopt this mindset, excessive losses could follow. Here are a few of the risks that commodities traders face.
1. Risk Versus Reward
Before placing any commodities trades, it is crucial to understand that it is all a game of risks against rewards. The potential for losses in the commodities market is vast and it is always advisable that an investor takes every step cautiously without trying to master the entire market all at once.
2. Position Sizing
Many people are often attracted to the commodities trading market because of the large trading sizing they can command via leverage. However, many traders miss the fact that this excessive position is the primary cause of risk-based losses in these markets. Commodities trades work similar to casino gambling. The more money you place, the higher the odds that your strategy will work against you. However, if you put your money in small increments, you will have significantly reduced your risks and let yourself trade for longer.
Commodities trading should not be viewed as a sprint but a marathon. Any trader who thinks he can get a full grasp of the market with just a little trading and zero patience is going to fail and lose all his money. If commodities trading were easy, we would all be doing it – and we would all be wealthy.