What are commodities?
Commodities are basic goods that can be used as building blocks for other goods. They can be broadly divided into two groups. Those that are extracted or mined; hard commodities, such as oil or gold. Alternatively, there are those that are grown or raised; soft commodities, such as wheat or cattle.
Commodities are an investable asset class that tend to behave differently to more traditional markets such as stock markets. As a consequence traders are known to purchase commodities as a way to diversify their holdings. For instance, the price of gold increased during the global economic crisis of 2008 when stock markets were in free fall. Gold is also perceived as a hedge against inflation.
How to trade commodities: commodity trading basics
There are numerous ways to trade commodities such as:
Purchasing the tangible asset. Traders can purchase the asset itself, which is the most direct method of investing in commodities. Such as someone buying gold bullion. However, they will need to store the asset until they are ready to sell. There is also the added complication of indivisibility, for instance, you can only buy or sell the set amount of a precious metal.
Investing in an exchange-traded fund (ETF). It is not uncommon for individuals to gain exposure to the commodities market by purchasing commodity-based ETFs. An ETF is a fund that is traded on an exchange. With commodity ETFs, there is the possibility to by physical commodity ETFs, where the ETF has an effective entitlement to that commodity. Alternatively, there are ETFs that attempt to track the value of commodity through comprising the fund of stocks in companies that are involved in commodities such as mining or agricultural stocks. This type of ETF can have a more volatile price with respect to the actual commodity.
Trading a futures contract. One way to trade commodities is by buying or selling a futures contract. A futures contract on a commodity is an agreement to buy or sell a fixed amount of a commodity at a certain price and specified date in the future. The trader will profit if there buy or sell order is aligned with the market price. Futures contracts are a derivative, this means that the value of the contract is derived from the underlying asset that is itself not owned.
Trading a contract for difference (CFD). Individuals can trade a CFD on commodities to gain exposure in these markets. A contract for difference is an agreement to pay the difference in the price of an underlying asset between the open and close of that contract. CFDs are derivatives that are traded on margin, meaning that you only have to put up a proportion of the value of the trade and effectively borrow the rest from your broker. Leveraged trading allows greater exposure to markets given a smaller initial amount. When you trade commodities on CFDs there are several advantages such as being exempt from stamp duty as well as being able to trader in greater volumes.
The benefits of trading commodities
Diversification. Commodities have a tendency to perform differently when compared to other asset class like stocks or indices. Due to this some traders use commodities as a means of diversifying their portfolio. However this is no perfect science.
Hedge against inflation. Due to the history of prosperity and wealth associated with precious metals such as gold, investors have a tendency to perceive gold as a hedge against inflation for instance. This does not always work but there is an additional comfort in trading one of the most historically valuable metals around.
Higher growth opportunities. Particular commodities can have significant growth in relatively short periods, depending on the wider economic environment. For instance, oil prices tend to shoot up when there is a substantial increase in demand due to unexpected economic growth that was not anticipated by oil suppliers.
How to trade in the commodity market and combat the associated risks
- Volatility. Commodity markets can be volatile so there are big opportunities for profit but also loss. Political events can ripple through the oil markets. However, by applying appropriate stop order and take profit limits you can manage loss if the market moves against your expectation.
- Asset concentration. Only trading one asset class is naturally more risky, regardless of that class. Always ensure you trade with a diverse portfolio of positions across sectors, asset classes and geographical regions.
Important: If you trade CFDs on commodities, please, bear in mind that many retail investors lose money when trading. You should consider whether you can afford to take the risk.
Read more about commodities trading:
How to trade commodities