Commodity trading offers an exciting opportunity for both new and experienced traders. But as with any new venture, it’s imperative that you understand the facets of trading commodities. There are some nuances that you will want to be aware of before diving in. We will address some of the core concepts around commodity trading, and provide insights and tips to help you avoid common pitfalls.
Commodity Trading Basics
Before we get into the nuts and bolts of what commodity trading entails, it’s important to understand what we mean when we refer to the term commodities in the context of the financial markets. Essentially, commodities consist of certain basic goods that are required for sustenance in our daily lives or other products that have universal demand and can be exchanged. There are four primary categories within the commodities market. This includes agricultural, meat, metal, and energy. Some examples of individual commodities include corn, wheat, soybeans, gold, silver, and crude oil.
Commodity trading involves the exchange of specific commodity products by different market participants, each of whom has their own set of goals for transacting in the market. The three main types of commodity traders include commercial hedgers, large speculators, and small speculators. We will be taking a closer look at each of these different market participants in the later sections.
One major benefit of investing in the commodities market is that there is often a low correlation between the equities market and the commodities market.
Because of this, investors who traditionally hold stocks and bonds in their portfolios, can add a commodity fund into the mix, allowing them to reduce the overall volatility of their portfolio. This can provide a higher risk-adjusted return than an equity only or equity bond portfolio.
Along with longer-term buy-and-hold investors, the commodity market also draws in a large group of traders known as speculators. Their primary purpose in the market is to try to profit from price fluctuations in various commodity products. Typically these speculators will specialize in a certain industry such as energy or metals in an attempt to gain a deeper understanding of the fundamental forces that drive the price of a specific commodity.
Another important consideration that newer traders and investors should be aware of when engaging in the commodity markets is the impact that weather can play in the overall price of a commodity. This is particularly true for agricultural commodities such as corn, wheat, coffee, and orange juice. Any major weather disruptions can cause a severe supply and demand imbalance, which can lead to huge price spikes.
Major Commodity Markets
Let’s now list some of the major commodities that can be traded. As we mentioned earlier there are four major commodity classes. This includes agricultural, meats, energy, and metals. Each of these different classes consist of various individual commodities. Let’s list out some of the more popular commodities within each category.
Corn – Corn is one of the most important commodities in the world. It is a vital source of consumption for both humans and animals. Additionally, ethanol fuel, which is an emerging source of energy, is made from corn.
Wheat – Along with corn, wheat is one of the most heavily traded agricultural products on the globe. The Midwest region of the United States is a major producer of wheat for both the domestic and international markets.
Soybeans – Soybeans serve as an important ingredient within many different food products. It is also used in the production of biofuels. There are three major producers of soybeans for the world economies. These include the United States, Argentina, and Brazil.
Sugar – Most people are familiar with the addition of sugar within food products, but many are not aware that it is also a critical ingredient in the production of ethanol fuel. The largest sugar producers in the world include Brazil, India, China Northern Europe, and Thailand.
Crude oil – Crude oil is the dominant energy source for most of the world. We rely on crude oil primarily for transportation purposes; however, it is also an ingredient within plastics and certain synthetics. The price of crude oil has a large impact on many other commodities. A sharp price rise or decline will influence the transportation cost component of virtually every other traded commodity.
Natural gas – Natural gas is used in the generation of electricity. Individuals and businesses rely greatly on the use of electricity in their daily lives. Without it, we could not have a fully functioning economy. The United States is the single largest producer of natural gas, followed by Russia, and Iran.
Gold – Gold is one of the oldest and most cherished commodities. It is mostly used in the production of jewelry products. Additionally, gold is viewed as a safe haven. At any time when there turmoil in the markets, investors will often flock to gold as a way to protect their assets. In recent years the price of gold has risen dramatically, as central banks have printed more and more currency notes.
Silver – Silver is used both for its aesthetic appeal in jewelry, and for its practical use in certain industrial products. Often the price of silver is highly correlated to the price of gold, however, there can be times when the price of two metals diverge. When this happens it can be indicative of a major price reversal in one of these metals.
Live cattle – There is a global demand for beef around the world. It is an industry that creates millions of jobs around the world. The three top producers of beef related products in the world include the US, Brazil, and the European Union.
Pork Bellies – The frozen pork belly market can be a very volatile market. Just as with live cattle, it is used primarily for consumption purposes. It is a very seasonal market and is often effected by dietary trends.
Key Players In The Commodity Markets
By now you should have a basic understanding of the commodity markets. Let’s move on and discuss the major market participants within these markets. We will look at the three major class of participants. This includes commercial hedgers, large speculators, and small speculators. Each of these groups interacts in the market for a specific purpose.
Commercial hedgers – The futures markets were originally designed around the needs of commercial hedgers. Commercial hedgers refer to the businesses that deal in the underlying commodity as a function of their operations. Hedgers routinely utilize the commodity futures market for price protection purposes. For example, Arthur Daniels Midland is a major grain manufacturer based in the United States. They run over 250 processing plants which convert wheat, corn and other related consumable commodities into actual food for consumption. They are considered a commercial hedger.
Based on their perception of future prices for corn and wheat, for example, they could engage in the commodity futures market as a way to lock in the price at today’s cash price for future delivery. This reduces the uncertainty associated with the future price of corn or wheat.
And so, if Archer Daniels Midland believes that the price for corn is going to rise over the next few months, they could purchase a certain amount of corn futures contracts today, which would serve to lock in a lower expected price, and take delivery at a specified future date. Commercial hedgers are seeking price stability for their underlying commodity. They are not engaged in the market for speculative purposes as are large and small speculators. For the most part, commercial hedgers profit from their underlying business operations are using the commodity futures market as a mechanism for risk reduction.
Large speculators – Large speculators refer to a class of traders that includes hedge funds, commodity trading advisors, big investment banks, and other major institutional participants. They’re primary motive in the commodity market is one of speculation. Trend following funds make up a good portion of this large speculator category. Their positions are often diametrically opposite to those of commercial hedgers.
For the most part, trend following hedge funds will add positions in the direction of the trend as the move progresses. Commercial hedgers, by their very nature, tend to do the exact opposite. They will be increasing their short positions as the market price increases. And conversely, they will be increasing their long positions as the market price falls.
Large speculators tend to profit when markets are trending, but will usually give back a large portion of their profits as the trend begins to lose momentum and eventually reverses. Large speculators are seeking to generate positive returns from their speculative activities. A major advantage for commodity hedge funds over commodity mutual funds is the ability for a hedge fund to take either long or short positions. Commodity mutual funds on the other hand tend to be long only, which can prove to be disastrous in a deflationary environment.
Small speculators – Small speculators are not much unlike large speculators in that they’re primary motive for interacting in the commodities market is for the purpose of generating profits from speculating. Small speculators do have one major advantage over their larger speculator counterpart. And that is to say that small speculators can be much quicker to market with their trading ideas and more nimble in exiting their positions as well.
While a large hedge fund may need several days to get in and out of a commodity trading position, a small speculator can enter and exit at will because of their relatively smaller position size. Due to their limited resources in both time and capital, most small speculators try to specialize in a particular commodity market. This is in stark contrast with many trend following hedge funds whom routinely monitor dozens and dozens of different commodity instruments.
Buying and Selling Commodities
There are a few ways that you can participate in the commodity markets as a trader or investor. Depending on whether you prefer to take an active role or a more passive role, you can choose the medium that works best for you. Let’s now take a look at the choices you have for investing in the commodities market.
Commodity Futures Market – We’ve discussed briefly some of the characteristics of a commodities futures market, along with some of the major participants within it. By understanding the roles of various market participants within the futures market, it will allow you to gain a deeper understanding of the order flow and price movements. As a small speculator starting out, it would make sense to try to specialize in a specific commodity market. Based on your skill set and preference, you may decide on either the agricultural, energy, metal, or meat markets.
There are two primary analysis methods that commodity traders use. This includes fundamental analysis and technical analysis. A fundamental analytical approach involves studying the underlying economic data in order to arrive at a potential trading decision. Technical analysis on the other hand incorporates a price action based methodology. There are many different forms of technical analysis that can be used by traders to gain an edge. Regardless, the underlying premise of technical analysis is that most of the news publicly available is already priced into the market, and that the way to gain a real edge is through a price analysis approach.
If you prefer studying commodity price charts then you are more aligned with technical analysis. On the other hand, if you prefer to monitor commodity market news, then you might be more prone to a fundamental approach. Commodity futures traders tend to be a much more active group, focusing on a shorter-term to intermediate-term trading horizon.
Stocks Correlated With A Commodity – Many traders and investors have gotten their initial education of the markets through the stock market. As a result, there is a certain group of traders that prefer to stick with the equities markets. They often view trading commodity futures as very risky and feel reluctant to engage in it. Now even though that fear may be misguided, nevertheless, nonprofessionals certainly need to be more careful in the futures markets due to the high leverage limit that is available within that market.
So, one approach to commodity investing would be to purchase a stock of a company that is closely tied to a specific commodity. For example, an investor who is bullish on gold and is interested in getting exposure to that commodity could opt to invest in shares of individual gold mining companies. Since there is often a correlation between the price of gold and the stock price of some gold mining companies, an investor could have an artificial position in the gold commodity through their investment in one or more gold mining stocks.
Commodity ETF’s – Exchange traded funds or ETFs have gained wide popularity over the last few decades. Essentially ETFs are comprised of a basket of like kind financial instruments. Some examples include stock index ETFs, sector ETFs, bond ETFs, commodity ETFs, and more. The beauty of investing in commodity ETF’s is that one can gain exposure to a large basket of commodities, and thus benefit from a more balanced diversified portfolio of commodities. A commodity ETF can be a great choice for investors looking for a passive approach to long only commodity investing.
By adding a commodity ETF to your overall portfolio, you can often realize a better risk-adjusted return when compared to equity only or an equity bond portfolio. A larger mix of non-correlated asset classes will often provide a better risk adjusted return.
Keep in mind, that there are some costs associated with commodity ETF’s, however, they tend to be fairly nominal. One of the biggest drawback of investing in long only commodity ETFs is the inability to take advantage of downtrends in the commodity markets.
Commodity Trading Exchanges
Commodity exchanges are a critical component of the commodity futures markets. Essentially, a commodity exchange is an organized market that helps facilitate trade via a regulated environment. Commodity exchanges are responsible for setting the rules for trading on the exchange. Some of the considerations include how to standardize commodity futures trading products, stipulating the actual trading hours, setting minimum margin requirements, creating procedures for taking physical delivery and more.
In a sense, commodity exchanges act as an un-biased referee with the primary purpose of facilitating trade among market participants. Commodity exchanges are tasked with making the order flow process as frictionless as possible, while maintaining the highest level of transparency for the benefit of all traders. Commodity exchanges help increase the efficiency in the market by helping to match orders and increasing the pool of liquidity available in the market.
Two of the major commodity futures exchanges include the Chicago Mercantile Exchange (CME), and the Intercontinental Exchange (ICE). They are both based in Chicago, Illinois and account for a large percentage of the worldwide volume in the major commodity products. The long-standing Chicago Board of Trade (CBOT) is also now part of the Chicago Mercantile Exchange Group. In addition, the New York Mercantile Exchange (Nymex), and the New York Commodities Exchange (Comex) are also under the umbrella of the CME group.
The majority of trading on the commodity trading exchanges these days is done electronically. This is in stark contrast to how business was conducted just fifteen or twenty years ago, when the major volume was passed through the commodity trading pits. Many of those former pit traders have had to transition to screen trading or been forced to look for other work altogether. One of the major advantages of electronic trading over Pit trading is in the speed of execution. Additionally with the volume transitioning over to electronic trading, the cost of commission and related transactions have reduced substantially as well.
Tips for Trading Commodities
Commodity trading online can prove to be a profitable undertaking for those who take the time to learn the nuances of trading commodities. If you’re interested in managing your own commodity trading account, here are some tips to help you along the way.
Be Aware Of Seasonal Trends – Some commodities tend to display a distinct seasonal trend. It’s important that you study the cycles within the specific commodity that you’re looking to trade. You may find that during certain times of the year that there is a strong bullish influence, while at other times of the year there is a strong bearish influence. Some of this can be attributed to the different supply and demand dynamics inherent within commodity classes, particularly in the agricultural market.
There are quite a few software products on the market that provide data on historical commodity trends. This can be helpful for a trader interested in studying seasonal trends. Knowing whether a specific market is following or diverging from its historical seasonal trend will make you more informed and allow you to trade in tune with the dominant cycle.
Correlations Are Important – Just as currency traders often rely on currency correlation tables to gauge the movements of two different currency pairs, commodity traders need to stay aware of relationships in price movements among the different commodities that they are tracking. Often you will find that commodities within a particular category tend to correlate in their price movement.
Knowing this can help avoid overexposure on a particular position. For example, many times the price of gold and silver will move in tandem. If you find that that correlation is above +90 for example, then you may want to refrain from having the same directional position in both markets.
Have A Plan To Hedge – Commodity futures markets can reward you with very quick profits when you’re on the right side of a volatile move. The flipside of that is that you can also suffer great losses when you’re on the wrong side of a volatile move. There may be times when the supply and demand imbalance will be so great in a specific commodity instrument wherein the market will trade limit up or limit down for several trading sessions. If you’re caught on the wrong side of that trade, you may find it impossible to exit your position. This can result in losses that are many times the magnitude that you may have originally anticipated based on your stop loss setting.
As a result, it’s worth knowing that when the futures markets are limit up or limit down, their related options market may still be open for trading. The point being that commodities traders should have a plan to hedge their positions when they need to. The commodity options market offers one such viable means for hedging futures positions.
Trading in the commodities markets can be quite exciting due to the potential for outsized gains. There are a few different ways that traders and investors can participate in commodity trends. Those seeking an active self-directed trading approach should take the necessary steps to educate themselves on both fundamental and technical analysis methods. They will need to find a methodology that provides a market edge along with one that suits their temperament. If you decide on this path you may want to become specialized as an energy commodity trader or metals commodity trader, for example.
Longer-term investors will be better served by investing in a diversified commodity ETF. This can help smooth out the equity curve of their stock and bond portfolio. It’s also important to do your due diligence and choose from the different commodity trading brokers that will best suit your trading style.