A commodity is a physical good that can be bought or sold on the commodity market. Commodities can be categorised into hard and soft varieties. Hard commodities are natural resources like oil, gold and rubber and are often mined or extracted. Soft commodities are agricultural products such as coffee, wheat or corn.
The most widely traded examples of commodities have well-established markets. There are around 50 major commodity exchanges globally. Crude oil is the most widely traded commodity in the world.
How does commodities trading work?
Investors buy and sell commodities through futures contracts on an exchange. This effectively means that prices are agreed upon months in advance. The exchanges standardise the quantity and minimum quality of the commodity. For example the London Commodity Exchange might stipulate that 5,000 bushels comprises one wheat contract. It would also state which grades of wheat could be used to satisfy the contract. All wheat meeting that grade and criteria will be sold for the same price. That’s regardless of where it was grown, and any slight variations in quality.
In the physical commodities market there will be an actual exchange of goods. A breakfast cereal producer might also buy a futures contract for corn with a delivery date months in the future. This way, the producer can guarantee the price (or exchange value) will not go up when it is delivered. This also protects the farmer from any price drops which might affect the sale of corn. Both parties can plan and budget accordingly.
Most commodity traders however do not take physical ownership of the goods. Commodities speculators or traders take a financial position (long or short) on a commodity. This can be done using an online trading platform. Commodities can also be traded as spread bets (UK and Ireland only) or contracts for difference (CFDs).
Some of the most popular commodities include crude oil, natural gas, gold and silver. Other popular commodities include heating oil, sugar, corn, coffee, wheat and soybean.
The most actively traded commodities will differ depending on how the markets are performing. For instance, a highly volatile petroleum market would attract more price speculators. This increases both volume and open interest.
Volume relates to the total number of contracts that are being traded. Open interest is the total number of open long and short positions in a market.
Commodities with high volume are often the most popular ones to trade. Low volume commodity markets can be prone to higher volatility or even wild price swings.
You can trade commodities through a commodity broker by setting up an online account. Futures contracts provide the most direct way to invest. These set an obligation to buy or sell a commodity at a fixed price and date. Buying into a commodity futures contract lets investors lock in quantity and price, which minimises volatility.
Commodities are also available to spread bet or trade as CFDs. With spread betting and CFD trading, you don’t take ownership of the underlying asset. Instead, you speculate on whether the price of the commodity you are trading will go up or down, and open a position accordingly. Spread bets and CFDs are leveraged products, which gives you a greater amount of exposure to the market. It is possible to maximise profits, but losses will also be magnified.
Many trading platforms offer demo accounts, which provides an excellent opportunity to practise before you start trading. You can familiarise yourself with placing orders, for example.
News trading involves following and responding to current social, political, and economic changes. News trading can be beneficial to both short- and long-term traders.
For example, if a report was published stating that demand for gold has hit a ten-year low, many traders would look to sell gold over fears that its value is likely to decrease. A sudden rise in the number of people selling gold could have an impact on your trades, as it would push gold prices lower.
High impact news bulletins can have an impact on the commodities market. By understanding how to take advantage of these events, you may be able to increase your profitability.
Many commodity traders take news and economic events into account when planning their trading strategy. They will constantly monitor and analyse the factors which are likely to affect the relevant commodities market, hoping to benefit from any changes in price movements.
Most commodity traders incorporate technical analysis into their trading plan. Technical analysis involves utilising previous price movement data to predict future price movements.
An uninformed investor would benefit from learning how to read charts. A basic understanding of charts could help you anticipate a potential market move. A starting point would be to look at the price chart of a market you are interested in trading.
Trading the trend is one of the golden rules of trading. Basic technical analysis suggests that the ideal time to buy an up-trending commodity is when it is breaking out to new highs, but technical analysis does not guarantee results.
Alternatives to commodity trading
There are a number of potential alternatives to commodity trading.
Forex (or currency trading) is the world’s most traded market. It’s built around buying one currency in exchange for another. Economic and political factors play a part here, making it an exciting market to trade. The market has no physical location, and is open to trade from Sunday night to Friday night.
You can also trade indices like the UK 100, Germany 30, and US 30. Indices gauge the value of a section of the stock market, and are calculated from the prices of selected stocks. Another alternative is to trade shares, including popular stocks like Apple, BP and Lloyds Banking Group. The treasuries market can also be traded. Examples of treasuries include government debt instruments such as gilts, government bonds, and treasury notes.
It is also generally recommended that you diversify your portfolio. Avoid putting all your eggs in one basket or a single trade. Does a market have sufficient liquidity and interest? Do some research before taking the plunge and trading or investing in a particular market. Successful traders tend to follow a strict trading discipline. Research, a solid trading strategy and sound money management skills are key.
CMC Markets is an execution-only service provider. The material (whether or not it states any opinions) is for general information purposes only, and does not take into account your personal circumstances or objectives. Nothing in this material is (or should be considered to be) financial, investment or other advice on which reliance should be placed. No opinion given in the material constitutes a recommendation by CMC Markets or the author that any particular investment, security, transaction or investment strategy is suitable for any specific person.
CMC Markets does not endorse or offer opinion on the trading strategies used by the author. Their trading strategies do not guarantee any return and CMC Markets shall not be held responsible for any loss that you may incur, either directly or indirectly, arising from any investment based on any information contained herein.
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