Commodities Trading: The Basics

Commodities Trading: The Basics

Commodities trading is in many ways similar to stock trading with respect to the mechanics of trading both markets. Stock trading is done at a centralized exchange like the New York Stock Exchange (NYSE). Similarly, commodities futures are also traded at a centralized exchange such as the Chicago Mercantile Exchange (CME). Just like stocks, both long and short positions can be taken on commodities futures. Both markets provide highly liquid markets with efficient trade executions for the assets that are traded. The same type of chart analysis, technical analysis, fundamental analysis can be effectively applied to both markets. And when done correctly, both markets offer a great opportunity to generate an enormous amount of profits. To review which are the best brokers to support commodities trading you can also utilise the compare brokers tool. This also allows you to select a broker that can cover your compete trading  / investing requirements.

Key differences

The differences between the commodities and the stock markets are in the underlying assets. A stock certificate represents a share of ownership of an underlying corporation. The price of the stock is based on the perceived value and strength of the corporation. This value varies from corporation to corporation, even if two different corporations produce the same exact product. By contrast, a futures contract for a commodity represents ownership of an undeveloped basic good that a producer provides that is used in the production of a finished product. The commodities futures contract does not represent any type of ownership interest in the producer of the commodity, be it a corporation or otherwise, only in its output. Another fundamental difference in the two assets is that when purchasing a stock, the purchaser takes actual possession of the stock, whereas a commodities futures contract does not require that actual possession of the commodity take place unless the buyer elects to do so.

Commodities of the same type must be universal and interchangeable. Although the quality may deviate slightly, uniformity across producers must exist in order for commodities markets to properly function. The commodities exchanges dictate minimum quality standard known as a basis grade in order for commodities to be allowed to trade. The objective is to maintain consistency from one producer of a commodity to another. For example, a barrel of oil will basically be the same product, regardless of the producer it came from.

Although many traders trade the commodities market for the sole purpose of generating profit from speculating on commodity prices, the original purpose of the market was for farmers, oil producers, and precious metal producers to have a way to hedge against future price risk for their production cycles. The use of this method to mitigate risk by farmers and producers predates the trading of stocks and bonds.

Tradable commodities fall into four type of categories which include precious metals (i.e. gold, silver, platinum and copper), energy (i.e. crude oil, heating oil, natural gas and gasoline), livestock and meats (including lean hogs, pork bellies, live cattle and feeder cattle), and agriculture (i.e. corn, soybeans, wheat, rice, cocoa, coffee, cotton and sugar). Commodity Futures Exchanges have standard futures contracts for every type of commodity that they list. However, each commodity type has different market characteristics and should be approached differently.

Precious Metals

The precious metals market includes gold and silver. These markets are where investors that foresee an upcoming bear market will tend to shift their capital to. Gold and silver are seen as reliable assets when stock markets are contracting due to inevitable cyclical recessionary periods experienced by the underlying economies of specific exchanges. The two weekly price charts below show an example of this phenomenon.

Chart #1: S&P 500 Weekly Chart

Chart #2: Gold Futures Weekly Chart

The shaded area of the weekly S&P 500 price chart shows the very strong downside move that resulted the financial crises of 2008. Investors panicked and immediately began transferring capital to other markets, including the precious metals market as is indicated by the strong upward move in the gold futures chart. Once the US stock market stabilized and returned to levels prior to the crisis, investors began shifting capital back into the stock market.

Energy

Some of the energy commodities markets are cyclical in nature. For example, the demand for heating oil increases during the wintertime for obvious reasons. Similarly, while the demand for gasoline and oil increases during the summer months when more driving for vacation trips takes place. Trading strategies should take these seasonal cycles into account. Some of the energy commodities are very susceptible to geopolitical risk. Organizations such as the Organization of the Petroleum Exporting Countries (OPEC) sometimes make unpredictable policy changes that have very significant and abrupt effects on the price of energy commodities.

Agriculture, Livestock, and Meats

Farmers are the principle participants of the agriculture, livestock, and meats commodities markets. Theses markets however do have sufficient volatility and liquidity for traders to capitalize on and capture profits from price movements. These markets do have a seasonal cyclical nature to them so capitalizing on the seasonal price movements is a popular strategy. However, these markets are very vulnerable to sudden and extreme price movements due to extreme whether events, or other type of unexpected disasters that significantly affect food supplies.

Strategies for Trading Commodities

The commodities market can accommodate every style of trader. The short-term intra-day scalpers and swing traders can capitalize on the daily volatility and range that most of the tradable commodities futures provide on a daily basis throughout the year. These markets are very liquid, and the spreads are reasonable enough to avoid excess slippage. A skilled day trader should have no trouble generating profits day-to-day. The inter-day position trader can capitalize on larger market movements that span over several day or weeks, and there are enough sizable swings to add to winning positions when appropriate. Long-term traders can capitalize on the long-term trends of some of the commodities that exhibit that characteristic. Gold for example, makes long-term trend price moves to the upside and downside, as seen in Chart #2 above. Catching one of these trends in either direction with a sizable position can lead to substantial profits. Leveraged accounts allow for traders to maximize the use of their capital, but caution must be taken because leverage can also accentuate losses.

If you are relatively new to trading, please have a look at our Best broker for beginners section.

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