The ChoosaBroker Trading Academy

How the Commodity Market Works

Physical commodities underpin the global economy. They are the fundamental raw materials that feed us, build and power our cities, and run our transport systems. This guide seeks to present a thumbnail portrait of what the commodity market is like, and how an average person cango about trading or investing in it.

Characteristics of Commodity Market

In the economic sense, a market is a mechanism that brings together buyers and sellers to further the transfer of goods and services. A commodity market is an organised marketplace that functions under established rules and regulations. It exhibits certain common characteristics, the most important among which are listed below:

  1. Commodities must be  homogeneous i.e., the different units of one particular commodity must all be identical.
  2. Commodities available for trading should lend themselves to grading based on quality.
  3. The supply of any commodity should not be monopolized by a few large entities or governments.
  4. Since the bulk of commodity trading takes place through futures contracts, the commodities must bedurableso as to last till the expiry of the contract.
  5. A commodity market should ensure that price continuity exists; meaning prices do not fluctuate substantially from one transaction to the next unless important new information becomes available.
  6. In an efficient commodity market, the transaction costs remain as minimum as possible.

Types of Commodity Assets

Tradable commodities can be classified in to 4 broad categories:

  1. Metals – Modern trading in metals can be traced back to the middle of the 19th century, when Britain, the world’s first industrialised nation, turned from being a net exporter to a net importer of metals to expand its manufacturing base. In the 21st century, the spectacular industrial rise of China has transformed the trade in metals and minerals. Gold, silver, and copper constitute the three most traded metals.
  2. Energy Commodities – Energy commodities have been pivotal to the growth and development of the global commodity market. Since its discovery in Pennsylvania in 1859, crude oil has steadily emerged as the world’s most traded commodity. The other notable energy commodities include natural gas, heating oil, and gasoline.
  3. Agricultural Commodities – Organized trading of agricultural commodities begun in the United States following the setting up of the Chicago Board of Trade in 1848. The major agricultural commodities include corn, wheat, soybeans, coffee, rice, cotton, cocoa and sugar.
  4. Livestock and Meat – The market for livestock and meat includes live cattle, feeder cattle, lean hogs and pork bellies. Hedgers and speculators are the dominant participants in this market.

The Economics of Commodity Market

Price volatility is a basic characteristic of commodity markets. In general, higher price volatility is typically the market’s response to information shocks. Price fluctuations can have large impacts on commodity market participants. While a decline in prices benefits consumers, they negatively affect producers’ income. Alternatively, while price gains benefit producers, they have adverse impact on the welfare of consumers.

Extensive research has been conducted on the economics of commodity price volatility. It is not simply the market’s response to unanticipated shocks, but also reflects the behaviour of market participants to expectations of future market conditions. For storable goods in particular, inventory holders respond to anticipated price rises by carrying forward stocks. Such arguments indicate that the determinants of commodity prices are varied and dynamic.

How to Invest in Commodities

Beginner investors to the commodity market are better off by initially focusing on commodity stocks, exchange-traded funds, and mutual funds. The more sophisticated commodity futures contracts can be difficult to fully understand when you are just starting out. Investing in commodities demands some extra learning, but it can give your portfolio the much needed diversification of risk and returns.

Investing in commodities is a lot different from trading other conventional asset classes. The biggest challenge with commodities is that unlike stocks or Forex, they are physical goods. There are three distinct ways to gain exposure to commodities:

  1. Investing Directly in Commodities: If you want to invest directly in a commodity, you will have to figure out where to buy it and how to store it. For precious metals like gold or silver that can be relatively easy. But with agricultural commodities, it can get a lot harder to deal with the logistics.
  2. Using Commodity Futures to Invest: Futures contracts offer an easy alternative to directly owning commodities. These contracts can be bought and sold on special futures exchanges, and will require you to open a futures brokerage account. It is important to point out that commodity futures often exhibit increased price volatility, which can likely expose you to the prospect of a big loss. Before you begin your futures trading journey, it is necessary that you invest sufficient time to understand how the market operates, and also gain information about the different risk management tools that can help contain your losses.
  3. Buying Shares of Companies that Produce Commodities: Another way to gain exposure to commodities is to either invest in commodity-related stocks, or through mutual funds that track the sector. For example, an oil and gas fund can be a good proxy for investors wanting to diversify in to the energy sector. Such a fund would own stocks issued by companies that are involved in oil exploration, refining, and/or distribution. Any fluctuations in the price of crude oil will have a direct bearing on such stocks.

Difference Between Stock Market and Commodity Market

The age old debate about which market is better to trade – the stock market or the commodity market – continues to do the rounds in financial circles. While some swear by the commodity market, others feel equity markets are better long-term bets. Let us try and understand the key differences between the two to get a better understanding of how each market operates.

  1. When you buy a stock, you become partial owners of the underlying company. Commodities, on the other hand, don’t offer any such rights, and are bought and sold pre-dominantly for speculative or hedging purposes.
  2. A stock’s price is primarily affected by how the underlying company performs financially. Commodity prices are broadly impacted by three main factors – global macro economic conditions, geo-political flashpoints, and natural disaster that threaten production and supply.
  3. Commodities are traded through a commodity broker who buys and sells on your behalf. Unlike stocks, most commodities are transacted through futures contracts, meaning that you buy or sell a future delivery for a commodity, rather than buying or selling for immediate delivery.
  4. Commodities are generally traded for shorter durations, while stocks can be held for years, even decades.

Final Few Thoughts

Though the different financial markets are closely interlinked, the differences between trading each one of them can be quite significant. In the end, it’s a matter of personal choice. As long as you are willing to put the effort to understand the key market drivers, you can potentially profit from whichever asset you choose to trade. If commodities aren’t for you,  have a look at options with some of the leading forex brokers.