It has been said that anyone thinking of commodity investment ought to retreat to a darkened room and lie down until the feeling passes. This, it is claimed, is a market for seasoned professionals only. Ordinary investors are well advised to keep clear.
With the possible exception of the foreign exchange market, no other field of investment has the same aura of mystery and even danger. Yet this is quite misleading. Trading in commodities is, essentially, no different from trading in any other asset class, such as shares or indices.
Investors take a view as to the likely demand for a particular commodity and the effect this will have on the price, in the same way as they form a view about any other security. Those whose judgment is proved correct will make money from their trades. But there are, of course, potential losses if the price moves the other way.
More on that in a moment. First, what is a commodity? The word is used loosely in everyday speech to describe anything of value (“The truth is a precious commodity”) but in financial markets it has a specific meaning, as a “primary” asset that is almost always turned into something else.
Thus, wheat becomes bread, crude oil becomes petrol and diesel, lean hogs become pork and bacon and iron ore becomes steel. There are exceptions, such as gold and silver, which do not need to be made into jewellery (although they often are) to have value – bullion is what is known as “intrinsically valuable”, in that it has worth in and of itself.
It follows from this that the final demand for commodities will come from large companies such as food manufacturers, oil refineries and car makers, which takes us to our first principle: investors’ trade in commodities takes place at the edge of the market, not the centre of it.
When a retail investor buys shares in, for example, General Electric, their motivation is no different from that of a professional manager at a large investment fund. Both wish to hold GE stock.
That is not the case with commodities. When General Mills, for example, buys wheat, it intends to use it, not least in its renowned breakfast cereal Wheaties. The commodity trader, by contrast, has no intention of taking delivery of wheat and is trading it in order to make money.
Commodities are traded in “contracts”. Each contract specifies three things:
- The quantity of the commodity concerned;
- The delivery date – whether immediate, “spot” delivery, or one month’s time or three months in the future or any other timeframe;
- The standard in terms of the quality of that commodity.
This last point is critical, because commodity markets cannot function without agreed, universal standards that ensure commodities of the same type are mutually interchangeable.
So, in the gold market, every “London good delivery bar” is identical. By contrast, gem diamonds are not a commodity, as each is different.
A second principle of commodity investment is to specialise. The deeper and more focused the trader’s knowledge, the greater the chances of success. Few will be able to stay on top of developments in half a dozen or more commodities. The investor should pick one – oil, gold, cocoa, natural gas or whatever is most appealing – and read as much as possible around the subject, learning what factors influence the price and studying past trading patterns.
A third principle is to cut losses while running profits. A stop-loss order to bail out of an unsuccessful position is essential to limit the investor’s downside. This can be set at perhaps ten or 20 per cent below the purchase price.
How to trade CFDs on commodities?
So how to trade in commodity markets? Traditionally, an investor would open an account with a commodity broker, who would either follow the investor’s specific instructions as regards trading strategy or would be given discretion to invest the client’s funds as they thought best.
More recently, contracts for difference (CFDs) have offered an alternative. As the name suggests, a contract for difference is an agreement, usually between a broker and an investor, in which it is agreed that, at the end of the contract period and depending which way the price has moved, one party will pay the other the difference between the price at the start of the contract period and the price at the end.
Whichever party most accurately forecast the prospects for the commodity in question will gain. CFDs allow investors to trade commodities without having to take ownership of the underlying contract.
If that sounds straightforward, that is because it is. The investor takes one view, the broker or similar counter-party takes another, and the contract is drawn up accordingly, on the time-honoured principle that “two views make a market”.
But when learning how to trade commodities, the investor will come across a handful of concepts that may require a little explanation. One is called “margin”, a word heard a lot in commodity markets. It refers to the ability of an investor to borrow from a broker to buy commodities having put up security – such as shares – equivalent to a minimum percentage of the sum they wish to trade.
Should the value of this security decline, the investor will face a “margin call” from the broker to top up the collateral to the required percentage.
Two other concepts new investors will encounter are “backwardation” and “contango”. Backwardation occurs when the spot price for a commodity is higher than the price being asked for a contract for delivery at some point in the future, a futures contract. Contango describes the opposite situation, with the spot price lower than the futures price.
Essentially, backwardation occurs when markets believe the spot price will fall, while contango reflects a market view that it will rise.
Finally, investors may feel confused as to the difference between futures and forward contracts. The former tend to be issued for trading purposes only and are never meant to run to physical delivery of the commodity in question, unlike the latter, which are used by the producers and industrial customers of commodities to arrange future deliveries at agreed prices.
Gold, for example, has traded between $272.65 an ounce on average in 2000 to more than $1,300 in Spring 2018, while Brent crude oil swung round from $136 a barrel in 2008 to $27.88 in January 2016 to about $65 in the Spring of 2018.
A second factor to bear in mind is that almost all commodities are priced in dollars, meaning the non-American investor’s domestic exchange rate against the US currency is an additional factor to be taken into account.
But with careful preparation and bearing the key principles in mind, commodity trading can be a fruitful and rewarding investment activity.
However, be warned that CFD trading is risky.