Commodities can be defined as basic goods or raw materials that are formed naturally in the ground, or that are being harvested in agriculture. In many cases, commodities are used as inputs in the production of goods and services around the world.
Keep reading to learn what commodities are and how to successfully trade with them.
As a result, their prices can easily influence financial markets and impact people’s day-to-day lives. A good example of this is the oil crisis in 1973, when the Organization of Arab Petroleum Exporting Countries put a few countries, like the US, UK, Canada, and Japan, on an oil embargo. This embargo resulted in a steep rise in oil prices, which resulted in an increase in gasoline price and long queues at petrol stations.
Commodities Market Definition
The main types of commodities traded are divided into four broad categories: energy, metals, agriculture, and livestock and meat. In this article, we will have a look at goods which can be traded in a commodities market from each of the abovementioned categories, and evidence some of the tickers that traders should follow for each of them.
There are two main types of commodities: hard commodities, and soft commodities. The former represents commodities that need to be mined or extracted from the ground, such as crude oil, gold, and copper. While the latter refers to agricultural products that are harvested or grown, like coffee, sugar, wheat, and livestock, such as live cattle and lean hogs.
The oldest futures and options exchange in the world is the Chicago Board of Trade (CBOT) which was founded in 1848. It used to trade commodities like gold, corn, silver, ethanol, and soybeans. Another leading commodities exchange was the Chicago Mercantile Exchange (CME), founded in 1898, it was the largest agricultural trading market. the CBOT and CME were merged in 2007, creating the leading futures and options exchange for many commodities.
Hedge for inflation
At times of increased inflation, many traders buy commodities to protect themselves from a weakening currency. Commodities are used as inputs to produce goods and services, and as a result, when prices for goods and services are increasing, this leads to a surge in commodity prices. Because commodity prices generally rise with inflation, this asset class can serve as a hedge against a depreciating currency.
Types of commodities:
Gold is a precious metal, and one of the most well-known hard commodities. During the time when markets are in turmoil, investors prefer to buy gold, as it is seen as a safe-haven asset, being a reliable metal with a certain value. In addition, it is used by traders that want to hedge against currency devaluations and high inflation rates. Moreover, gold is mainly used in producing jewellery and electronics. Investors can trade gold on the London Metal Exchange, under the ‘LME Gold’ indicator. Like most other precious metals, its value is expressed in the troy ounce (31 grams).
Silver is used in a variety of industries, varying from jewellery to electrical components. It is a good investment choice for active commodity investors, as its price fluctuates more than gold. Traders can follow silver’s price on the Nasdaq, under the ‘SI:CMX’ indicator.
Copper is one of the most demanded metals around the world. Due to its conductive properties, it is mainly used for electrical wiring, industrial equipment components, and plumbing. As a result, this metal is consistently in high demand in a growing global economy, offering traders a bullish (positive) outlook on the markets. Investors can trade copper on the London Metal Exchange, under the ‘LME Copper’ indicator.
Platinum is used in a variety of industries, ranging from automotive to electrical equipment. Traders that are willing to invest in this noble metal are taking a bullish (positive) perspective on the economy, betting that industrial production will continue to grow. In a similar fashion as other commodities, it moves inversely with the USD, offering a hedge against a devaluing dollar. Investors can follow platinum’s price on the Nasdaq, under the ‘PL:NMX’ indicator.
Corn is an important food source for people and livestock, such as hogs and cattle. In addition, it is used to sweeten products like soft drinks, candies, and even ketchup. The price of corn is fluctuating between summer and winter seasons, with prices being low during the summer, and high in the cold season. However, trading agricultural goods in the long term can be a lucrative activity, as corn prices are expected to rise with the growth in population and limited food supply that is available. Investors can trade corn futures on The Chicago Board of Trade (CBOT), under the ‘C 1:COM’ indicator.
Coffee is a widely used commodity in the day to day life, making it one of the most traded commodities. What makes it unique is the fact that most of the production takes place in just a few countries: Brazil, Colombia, Indonesia, and Vietnam. However, it is widely consumed around the world, with a growing demand coming from emerging markets. Traders can follow coffee futures on the Intercontinental Exchange (ICE), under the ‘KC’ symbol.
Sugar is most notably known to be a sweetener, but more recently it has also been used in the production process of ethanol. The market is predicted to grow in the future, as demand is increasing from developing countries. Sugar is grown mostly in India, Thailand, China, the US, and Russia. Investors will find it challenging to trade sugar, as governments around the world have intervened constantly with subsidies or import tariffs, thus distorting its price. Traders can search for sugar futures Intercontinental Exchange, under the ‘SB’ indicator.
Soybeans are used as a meal for livestock, in the production of biofuels, and soybean oil is commonly found in bread, snacks, and sauces. The main market driver for soybeans is the rising demand from emerging economies. Soybeans are mainly produced in the US, Brazil, and Argentina. Although the demand is surging, investors will see that this is a tricky commodity to trade. China, which is the largest buyer of soybeans, has imposed tariffs on seeds imported from the US in early 2018, leaving US farmers with huge losses and unsold crops. Investors can follow soybean future prices on The Chicago Board of Trade (CBOT), under the ‘ZS’ symbol.
- Crude oil
Crude oil is the commodity with the biggest impact on the economy. Being mainly used in transportation, its price is influencing all the other products and services on a global scale. In addition, it is also used in the production of fertilizers, synthetic textiles (polyester, nylon, spandex, acrylic), cosmetics, and plastics. The top oil producers are Russia, Saudi Arabia, and the US.
Crude oil is a popular choice for traders, as it is very volatile, being easily influenced by political events and socioeconomic situations. For example, the decisions taken by the Organization of the Petroleum Exporting Countries (OPEC) cartel, and sanctions imposed on Iran’s oil industry, have a significant impact on the oil’s price. Investors can follow the two main oil indices: West Texas Intermediate (WTI) and Brent Crude Oil with prices expressed in barrels.
Gasoline (petrol) is a fuel obtained from crude oil processing, being the main product made in refineries. Consumers generally use it in cars, motorcycles, and light-duty trucks. Gasoline prices have a significant impact on the economy, as the demand for it is inelastic, meaning that people will need to use it regardless of its price. Traders can search gasoline futures on the Chicago Mercantile Exchange (CME), under the ticker ‘RB’.
- Natural gas
Natural gas is a commodity used in a wide range of residential, industrial, and commercial applications. Some notable examples are its use for heating, and as an input for fertilizers. Its price generally follows the oil’s movements and can be influenced by political decisions. A good example are the American deliveries of Liquefied Natural Gas (LNG) to Europe, which put pressure on Gazprom to reduce its prices for some European countries. Traders can check natural gas futures rates on Nasdaq, under the symbol ‘NG:NMX’.
Livestock and Meat
Livestock and meats are classified as soft commodities such as corn and sugar, as they are grown, not mined. This commodity generally includes animals like hogs, feeder cattle, live cattle, and meats like pork bellies. Some of the products made from live cattle include hamburgers, steaks, leather, and piano keys. For these commodities, investors can follow a few tickers, such as Nasdaq’s Live Cattle ‘LE’ symbol.
Characteristics of the commodities market:
In the past decades, there has been a constant increase in living standards and GDP in developing countries. This led to a surge in the demand for commodities, generally having an upward impact on their prices. For example, big manufacturing countries, like China and India represent the biggest buyers of commodities such as crude oil, iron ore, and copper. As a result, if these economies reduce their demand for commodities, there would be a drop in prices, and many countries will be affected.
Supply and demand
With the change in supply and demand for a commodity, its price will also change. The basic rule is that when demand for a commodity is surging, its price will rise as well. In addition, a commodity price can also increase if there is a fall in the supply of it. On the other hand, a decrease in commodity price takes place when there is an oversupply and a decreasing demand. A good example for this is the recent pandemic, when the OPEC organisation kept its daily oil production high, with most oil storage facilities filled around the world, and a record low consumption, as the world went through the lockdown. This has prompted the WTI oil benchmark to decline sharply, falling for the first time to below – USD 30.
Substitution means that markets will try to use cheaper options when possible. If a commodities price is increasing, buyers will try to find cheaper alternatives. When a suitable alternative is found, it will be purchased more, leading to a reduction in demand for the original commodity, thus reducing its price. A good example of this is the decrease in the use of copper for industrial applications, many manufacturers starting to use aluminium instead.
The US Dollar is the world’s reserve currency, and as a result, most of the commodities are priced in USD. This means that the commodity prices are directly correlated with the value of the dollar as compared to other foreign currencies. Therefore, if the dollar increases in value, traders that purchase commodities in other currencies will not be able to purchase as much as before.
Weather has a key role to play in determining commodity prices, having a particular impact on agricultural commodities. Adverse weather can lead to the destruction of the harvest, reducing the supply, and thus increasing the prices. On the other hand, favourable weather can lead to higher production, an increase in the supply, and a reduction of the commodity prices. For example, in early 2017 the UK shoppers were hit by a surge in the prices of vegetables such as tomatoes and courgettes, as cold weather destroyed much of the crops imported from Spain and Italy.
Weather is also having a big impact on energy commodities. Low temperatures drive up the demand for natural gas and heating oil, while the hot temperatures lead to an increase in demand for electricity, as air conditioning is used more.
How does commodities trading work?
In the past commodities used to be traded physically, whereas nowadays most of the commodities trading is done online. In the list below traders will find some of the most popular ways of trading commodities online.
Futures are contracts to buy and sell a specific commodity at a fixed price and at an exact date in the future. Generally, when the futures contract expires, the commodity would be transferred to the buyer. However, nowadays this is not always the case, as many traders are using futures to speculate commodity prices, without having the intention to own the commodity when the contract expires. Simply put, if commodity prices surge between the acquisition and the expiry date of the contract, an investor can sell the futures contract at a profit. On the other hand, if the commodity price goes down, the investor will mark a loss.
Leverage is one of the major benefits of trading futures, as it allows investors to enter a bigger trade than what they could buy with their own funds. For example, when a futures contract is available for purchase with a leverage of 1:15, means that for every GBP invested, traders can hold GBP 15 worth of the commodity they chose. However, beginner traders should keep in mind that evaluating future commodity prices can prove to be tricky, and that leverage can increase losses, especially when markets are very volatile.
Options are a type of derivative that allows traders to bet on the price change of a commodity, without having to purchase it straight away. Similar to futures contracts, options can also make use of leverage.
There are two types of options contracts:
- Call option contract – its owner has the right but not the obligation to purchase a commodity futures contract at a fixed price (strike price) on or before a specified date (expiration date)
- Put option contract – its owner has the right but not obligation to sell a commodity futures contract at a fixed price (strike price) on or before a specified date (expiration date)
Traders can sell a call option for a profit when the price of a futures contract is bigger than the strike price. For a put option to generate profit, the price of the futures contract must be lower than the strike price. As a result, traders should take into consideration commodity prices and market drivers that can influence them, before investing in option contracts.
An ETF (exchange traded fund) is a fund that invests in a pool of financial assets. Traders can invest in them through the stock exchange or via a commodities broker. ETFs allow investors to take advantage of the volatility in commodity prices without investing directly in futures contracts.
ETFs that invest in commodities follow the price of a commodity or a pool of commodities using futures contracts, or by keeping the actual commodity in storage.
However, investors should be aware that using ETFs for commodities trading has its drawbacks: not all commodities have associated ETFs, ETFs mirror the risk of the assets they invest in, and big price movements might not be reflected by the underlying ETF.
Mutual and Index funds
Mutual funds can invest in stocks of companies from commodity-specific industries, such as mining, energy, and agriculture. Investors should be aware that the price of a mutual fund can be influenced by factors such as fluctuating commodity prices, company-specific factors, and stock market volatility.
On the other hand, there are a few commodity index mutual funds that hold futures contracts and commodity derivatives, offering investors better exposure to commodity prices.
Advantages of investing in commodities through mutual funds include added diversification to any trader’s portfolio, professional money management, and higher liquidity. However, investors must take into consideration that some mutual funds have high management fees, and a few can have sell charges.
Using stocks to invest in commodities is a strategy applied by many investors that want to enter the market related to a particular commodity. For example, traders interested in the gold sector have the option to purchase shares of mining companies, refineries, or any other company that deals with bullion. According to theory, the revenues of these companies are related to the commodity that they are trading. As a result, if the commodity price goes up, so should the companies share prices, and vice-versa. However, this is not always the case, as there are company-related factors that can impact share prices, without being related to the desired commodity.
Commodity pools and Managed futures
A commodity pool operator (CPO) is an entity that takes money from investors and then puts them together into one pool, with the purpose of investing them in options and futures contracts. The CPOs release annual financial reports and account statements, so investors can easily track its performance. In most cases, CPOs have a commodity trading advisor (CTA) which provides investment advice on the pool’s trades.
Advantages of investing in a CPO include the structures ability to invest more, as it has more funds available than an individual trader, and the benefit of the professional advice offered by the CTA.
Investors that want to trade commodities have a wide range of financial instruments that offer access to the commodities market. Among those, newcomers will appreciate the ease and reduced risk offered by investing using ETFs and stocks, while more advanced traders might choose futures and options contracts to grab opportunities offered by specific commodities.
Traders should keep in mind that commodities are considered to be a risky investment due to their price fluctuations caused by uncertain events which are impossible to predict, such as disasters, a changing climate and more recently, epidemics.