The ChoosaBroker Trading Academy
Commodity markets are one among the very few investment vehicles that empower even an individual with limited capital to make astronomical profits in a relatively short span of time. Just ask the “Prince of Pit,” Richard Dennis, who borrowed $1,600 in the early 1970s and turned it into a whopping $200 million fortune in a little over ten years, speculating solely on commodities.
In this lesson, we will learn –
What is a Commodity?
In simple terms, a commodity may be defined as a raw material that humans employ to create a more liveable world. Humans use agricultural products as sources of food, utilize metals to build tools, and consume energy to sustain themselves.
Trading and investing in commodities is as old as civilization itself. Archaeological evidence suggests that rice futures may have been traded in China as far back as 4,000 BC. In the United States, commodities trading began in the grain markets sometime in the middle of the 19th Century, which led to the eventual creation of the Chicago Board of Trade in 1848.
In the modern financial marketplace, to be considered a commodity asset, any product must satisfy three basic criteria:
- It must be standardized.
- It must be usable upon delivery.
- Its price must fluctuate enough to justify the creation of a market for it.
Types of Commodities: Agricultural and Non-Agricultural
There are various types of commodities available to the average retail trader. Broadly, they can be classified in to three categories:
- Soft Commodities – A soft commodity is a general label used to denote agricultural commodities that are grown on farms. Wheat, coffee, corn, cocoa, sugar and soybean are some examples of soft commodities. These have a limited shelf life and are prone to damage in the absence of favourable weather conditions. As such, the prices of soft commodities tend to be much volatile in the short term.
- Hard Commodities – They are either mined from earth or extracted from naturally occurring resources. Crude oil and gold are the two most widely traded hard commodities. Some hard commodities are also produced by processing other hard commodities. For example, heating oil is an important by-product of crude oil refining. Hard commodities are not perishable and are easier to store compared to soft commodities. Besides, weather seldom directly impacts production and supply. The prices of hard commodities are influenced more by global macroeconomic conditions and geo-political outlook.
- Meat Commodities – These are futures contract on livestock reared for meat. The four main meat commodities are live cattle, pork bellies, feeder cattle, and lean hogs. Meat futures are highly leveraged instruments and gain or lose in value depending on demand for the underlying asset.
Basics of Trading and Investing in Commodities
Commodities can be traded in both the spot market and the futures markets. Buying in the cash or spot market entails paying the producer of the commodity for immediate delivery of the physical product. The spot price is the last traded market price. In major spot markets, where large quantities of commodities are traded, set standards are applied as far as quality is concerned, eradicating the need for the buyers to visually inspect the product before delivery. Spot markets are predominantly utilized by businesses and producers, who actually use the commodity they are transacting in.
Alternatively, commodities can be traded in the futures markets, which is where the vast majority of retail traders, investors and speculators operate. Commodity futures are traded through regulated exchanges. The New York Mercantile Exchange is the world’s biggest physical commodity futures exchange. Here, each futures contract is a legally binding agreement between two parties to exchange a specified quantity of a commodity at some point in the future at a price fixed today. However, in most cases, there is no actual delivery of the physical product, as commodities speculators favour rolling over their open positions or closing them out before expiry of the contract to book unrealized profits.
How are Commodities Priced?
Commodities are traded on exchanges, where forces of demand and supply, in the guise of traders and investors, interact with each other to fix their market prices. If demand for a commodity exceeds supply, prices rise. Conversely, when supply eclipses demand for the commodity, prices fall.
Taking trading volume into consideration, the commodities market is the second biggest global financial market after Forex. Due to its sheer size, it sometimes becomes difficult to ascertain the exact agents that bring about changes in the price of a commodity. Nevertheless, a few general factors can be regularly seen to influence the values of commodities, and are enumerated below:
- Changes in Weather – For starters, unexpected shifts in weather patterns can have a great impact on commodities, especially the agricultural kind. Since production is heavily reliant on climatic conditions, unusually hot summers or severe winters or too much rain or acute droughts can wreak havoc with production, curtailing supply in the market.
- Changes in Political Conditions – Geo-political uncertainty is a dominant market force as far as hard commodities are concerned. Any flare up in tensions in the Middle East for instance can trigger supply disruption fears, boosting prices of crude oil. This is exactly what happened when Saddam Hussein invaded Kuwait in 1990, propelling oil from $17 per barrel to $36 per barrel.
- Changes in Economic Conditions –The commodities market is one of the first to react to changes in the global economy. A downturn in an economy reduces the purchasing power of consumers, who in turn cut-back on their commodity expenses, stifling demand. In addition, commodities are a natural hedge against inflation, often producing the first signs of a general price rise. If inflation is imminent, commodity prices typically rise.
Commodities vs. Stocks
The age old debate about which market is better to trade continues to reverberate in trading communities and forums. While some market participants swear by the equity market, others feel commodity markets are a better long-term bet.
That doesn’t mean that an investor cannot hold a portion of each of these assets in their portfolios. Most advisors in fact recommend a healthy balance of both equities and commodities to diversify an investor’s risk profile. Gold, in particular is an excellent hedge against losses in the stock market, and should be an integral part of any model investment portfolio.
There are a few notable differences between how the commodity market and the stock market operate. Let us look at five of them –
- Unlike stocks, investing in commodities is primarily done through the futures and options route.
- In the commodity market, a single product may have several varieties or grades. For example, three different gold contracts are available on the Chicago Mercantile Exchange – a standard 100 troy ounce contract, a mini 50 troy ounce contract and a micro contract of 10 troy ounces. In the stock market, one unit of a security does not differ from another unit of the same security.
- An equity investor can generate a steady income flow from company dividend payments. Commodities don’t yield any dividends.
- Investing in commodities is free from the perils of insider trading. Also, there are no company specific risks as experienced in stock markets.
- Commodity assets are often influenced by seasonal factors. Seasonality is virtually absent in stock markets.
Final Few Thoughts
Commodity futures play an important role in a balanced investment portfolio due to their historic negative correlation with the returns of stocks and bonds. Obtaining these benefits, however, requires your willingness to hold this volatile asset grade over the longer time frame.