For an average American, the importance of commodities cannot be understated. As of December 2020, the prices of commodities keep surging, with minerals and metals showing as much as 10.4% growth. Apart from these, the commodity market also consists of energy sources like heating oil and gasoline as well as meat and livestock.
Many investors depend on commodities when the market is unstable since their price movement is contrary to that of stocks. But, before jumping in, you need to know about the basics so you can find your way around the market.
What are commodities?
Commodities are asset groups that are essential to our daily lives, like metals, fuel, and food items. Commodities can be exchanged and classified as dynamic goods that can be traded, with the exception of money and actionable claims. Individuals normally don’t invest in commodities because of their bulkiness, and you will mostly see large companies taking part in the commodity market.
There are different grades by which commodities are categorized, and those belonging to the same grade can be interchanged with one another, no matter who the producer of the commodity is. Let’s say there are two different mining companies located in Phoenix and Denver, both producing high-grade copper. To a purchaser of copper, the purity of the commodity is all that matters, and it makes no difference to those who produced it.
What is commodity trading?
Commodity trading is the practice of transacting in different assets like food ingredients, food items, precious metals, as well as gas and oil. It is an ancient practice that precedes the stock markets, with the first recorded deal having taken place in Amsterdam in the 16th century. Nowadays, you can access a large number of markets with a simple click of a mouse or by using a Smartphone.
Although commodity trading involves the transaction of commodities, there doesn’t always need to be a physical exchange. These days, the more common practice is to use a futures contract for this purpose, where an item must be bought or sold off by you at a certain date in the future. Thus, a futures contract lets a trader place a wager on the price shift for the commodity.
For example, if you get an indication of a bullish scenario, you would want to purchase futures or enter long trades. Conversely, upon getting an indication of a bearish market, you should enter short trades or in other words, sell the futures. Commodity exchanges are the typical conduits for future contract trades, and two of the largest such exchanges in the USA are located in New York and Chicago.
How to trade commodities?
In order to trade in commodities, you need to follow these steps:
- Select the commodity. First, you need to decide on the commodity you wish to transact in, such as food items, oil, gold, etc.
- Make a buying or selling decision. Enter a long trade when you predict the price rising, or enter a short trade when you predict it falling.
- Decide the unit size. Next, you need to figure out how much you want to bet on each spread or the amount of contract for differences you are trading in. The price per unit is not the same for all the assets.
- Risk management. This step involves the use of stop-losses or GSLOs for managing risks. The latter works in the same way as the former, except for the fact that GSLOs give you the guarantee that your trade will be closed at a specified price, notwithstanding the gapping or instability in the market. In case the GSLO is not activated, you get the premium back in full.
- Monitoring. Following the placement of your trade, you need to keep an eye on the open positions to see how you are faring in live trading. You also need to monitor the take profit limits and the stop orders. Keep in mind that the losses can be more than your investment amount.
- Close the positions. If the trade is left open and the take profit order and stop-loss are not activated, you should close it out as per your convenience.
Types of commodities
The different types of commodities are as follows:
- Metals. This category includes copper, platinum, gold, etc. Because of their reliability, many people depend on metals when the market is unstable or bearish.
- Energy. These include fossil fuels like gas and oil. Their prices are influenced by global economic shifts and production changes.
- Meat and livestock. These commodities include feeder and live cattle as well as meat cuts.
- Agricultural. Food and cash crops constitute the agricultural commodities category.
What are the advantages of commodity trading?
The advantages of commodity trading are as follows
- Diversified portfolio due to the prices having a negative or low correlation with other instrument classes.
- Protection against inflation due to the values being maintained even when a currency is depreciating.
- Commodities act as a buffer against calamitous events since they cause the prices to rise.
- Can be easily liquidated.
- Lower margin and high returns.
What are the risks of commodity trading?
Trading commodities, you can face the following risks:
- Issues with paperwork, delay in the delivery of shipments, and other operational problems.
- Regulations set by countries like trade embargos.
- Unexpected basis shift harming the margin.
- Asset performance risk.
- Not having the ability to sell the asset.
Conclusion – Should you invest in commodities?
If you are a novice trader, you ought to steer clear of commodity trading since you need to properly understand how the price moves in order to be successful. If you do wish to enter the commodities market, you need to clearly establish your objectives and consult experts as well, since it is high risk and high return investment.