A Beginner's Guide to Commodities Trading (2024)

FP Markets

13 February, 2023

20 Minutes read

A Beginner's Guide to Commodities Trading

Reading Time: 20 Minutes

Introduction to the Commodities Market

The commodity market descends from the first form of human trade thousands of years ago, the trade of natural goods and raw materials. Whereas these used to be exchanged through a bartering system, more sophisticated forms of exchange are now available.

The physical exchange of commodities still takes place around the world every day. Other forms of investment in the commodities market involve trading futures contracts, options trading and CFDs (Contract for Differences). Commodity investment is also possible through ETFs (Exchange-Traded Funds), commodity-related stocks and larger funds on the equity market. Like other financial asset classes, investing in commodities requires specialised knowledge and skill.

Different Commodities

The commodity market is divided into different sections:

• Commodity metals include precious metals such as gold, silver and platinum and industrial metals such as zinc, aluminium and copper.
• Agricultural products include grown and harvested goods such as coffee, wheat, cocoa and sugar.
• Energy sources include crude oil, natural gas, and renewable energy, such as wind and solar.
• Livestock consists of all domesticated animals raised in an agricultural setting to provide commodities.

Commodities are further broken down into hard and soft commodities:

• Hard commodities consist of natural resources that are mined/extracted. This includes metals and energy sources.
• Soft commodities represent agricultural products and livestock.

Due to their cyclical nature in terms of planting and harvest, supplies of soft commodities can be easier to forecast.

While the equity market consists of stocks and shares in companies (pieces of paper rather than actual products), the commodity market hinges on real physical products. Commodities are the building blocks of the global economy and the building blocks of everyday life. From the food people eat to the materials used to build their houses and the fuel that powers their vehicles, the world hinges on the availability of these goods and resources. Their scarcity can have a terrible effect on the world economy, therefore supply and demand are the most significant factors affecting the global commodity market.

Best Commodities to Trade

Hard commodities, more specifically precious metals (gold and silver) and energy sources (oil and gas), tend to dominate the consensus over the best commodities to invest in as they have the highest trade volume on the market. Their rarity and value mean demand is likely to remain high, helping to maintain increased prices. Gold and silver have various industrial uses and possess long-term value preservation. Crude oil is refined into different products beyond diesel and gasoline, which, together with natural gas, power a substantial percentage of the worldwide economy. Consequently, demand is constant, and activity is high in the market.

Through the 17th and 18th centuries, huge amounts of gold and silver were extracted from the Americas, providing immense wealth to European countries. This form of wealth has remained, with a lot of intrinsic value in these precious metals beyond currency, intertwining with historical symbols of wealth. These metals offer portfolio diversification and value preservation due to their scarcity and value. Central banks also hold gold in large amounts worldwide as the value diminishes less than currencies over time.

The investment form can vary, from buying physical gold and silver to futures contracts or related stocks. Holding stocks in each part of the process, from mining to production and jewellery companies, is considered a notable investment.

Crude oil and natural gas have been the most significant wealth-driving force of the 20th and 21st centuries, revolutionising the global economic landscape. For example, the Middle East has been revolutionised over the past century through the extreme wealth gained through oil and natural gas harvested in the area. It has transformed small and formerly poor countries into the richest in the world, as seen with Qatar.

The worldwide economy depends on these commodities and demand is constant with prices elevated. Given these energy sources' significance and power, they are actively used for geo-political warfare. In 1973, the Arab countries that controlled most of the world's oil retaliated against Western support of Israel by withholding oil, creating a blockade. This created chaos in the Western world, with the price of oil skyrocketing. This phenomenon also occurred recently due to the Russian invasion of Ukraine, where many countries blocked Russian gas, which was used to power a significant portion of Europe. Therefore, the price of natural gas rose significantly. Since the invasion, sanctions on Russian goods and subsequent consequences have caused various commodity price movements (volatility). Geo-political conflicts considerably impact the price of commodities, especially energy sources.

Many alternative energy sources have been put forth, such as solar, wind and nuclear. However, they have yet to reach the demand level for natural gas and crude oil. Beyond the use of different forms of fuel, crude oil can be used for plastics, clothing materials and many other day-to-day products. This multifaceted use increases demand, making oil one of the most desired natural resources. These resources are among the most liquid commodities to trade. The volatile nature of the market provides trading opportunities. There remains, however, the risk associated with these investments, as price movements can also go against the investor.

How to Trade Commodities

Commodity traders tend to specialise in one specific commodity or section of the commodity market. Due to the extensive factors that lead to price changes, centralising focus usually benefits the outcome of their investments. Technical and fundamental analysis is critical for any trader. Understanding daily market changes and trends is vital for short-term trading. Analysing significant geo-economic factors on a macro level allows traders to predict long-term trends and changes in commodity values. There are various markets and forms of investment surrounding commodities.

Spot Market

The spot market is the commodities equivalent of equity day trading, where short-term success can be achieved through technical analysis. By observing single-day price fluctuations, traders can profit from a volatile market. Also referred to as the physical market, the spot market is where buyers and sellers exchange commodities with the intention of immediate delivery. There are two main buyers in this market, commercial customers and speculators. For example, Starbucks is interested in buying large coffee beans for prompt delivery.

On the other hand, speculators look to profit on anticipated rises and dips in commodity prices. As some materials are mined or harvested at certain times, there are moments of an influx of supply into the market, which causes price changes. Whereas large amounts of supply into the market drives prices down, a rise in demand would see prices rise. For example, abnormally cold weather conditions cause growing demand, generally underpinning gas prices.

Derivatives Market

The derivatives market opens the investment space for commodity traders, both for speculation and hedging.

This market involves forwards, futures, swaps and options. Futures contracts are based on an agreement on a set price in the future for a particular commodity. These contracts are helpful for companies that know they will need a specific commodity in the future and want to avoid taking the risk of severe price movements. For example, an airline can enter a futures contract for oil at a set price, consequently reducing price risks.

Trading activity in the futures market remains high. Therefore, it’s common to see short-term investors speculate on certain commodities, purchasing futures contracts without the intention of physical delivery (cash settled). Speculators use futures contracts to either short (sell) or long (buy) single or multiple contracts. These investors look for commodities with high liquidity and short-term volatility to profit.

Investors also hedge their commodity investments using the derivatives market, with some favouring options trading over futures.

CFDs (Contract for Differences)

Investments in the commodity market can also occur through CFDs, a financial contract (another form of derivative) that allows an investor to speculate on the direction of a specific commodity's price. CFDs pay the difference between a trade's opening and closing price through a brokerage. Essentially, this contract allows an individual to invest in the commodities market without ever intending to receive the physical commodity, solely speculating on price movements. Unlike future contracts, there is no specific settlement date. The investor is simply predicting the direction of a particular commodities price. If the investor expects the commodity will gain in value, the investor goes long, whereas if the investor thinks it will go down, the investor goes short. Due to the volatile nature of the market, there are various price movements during a single business day, providing multiple opportunities for investors. These contracts allow for high leverage, with brokers allowing investors to increase the volume of their position beyond their account balance (account equity). While this means potential profit is high, the risk of loss can also be magnified by high leverage.

ETFs (Exchange-Traded Funds)

Commodity ETFs are made up of various securities used to track the price of a specific commodity or group of commodities. They operate like a mutual fund. However, they can be purchased on the equity market like a stock. ETFs allow for portfolio diversification as a single ETF can hold multiple underlying assets and operate at a lower transaction fee than various stocks. For portfolio managers looking to hedge, ETFs are popular as they simplify investment. For example, whereas buying and selling gold used to be highly complicated logistically, purchasing gold ETFs is as simple as buying a stock and can be done from any mobile or laptop connected to a broker around the world. Their popularity also comes from giving investors exposure to the commodities market without learning about futures and derivatives while being highly liquid, therefore, easy to exchange.

Benefits of Commodity Trading

The profit potential and hedging capabilities are the main benefits of the commodities market. The growth of the global economy tends to correlate with the rise of commodity prices as there is more industrial demand due to increased demand for consumption. The commodities market, therefore, can offer better prospects than the equity market in times of inflation.

When companies lose value (a decline in the stock market) in an economic contraction due to inflation, this can make borrowing expensive, which can eventually weigh on commodity prices.

Another reason to invest in commodities is their volatility. This favours short-term traders as without volatility generating a gain is difficult. However, consider that volatility is also a proxy for risk and should be contained using specific risk-management techniques. Added to this is the ability to leverage investments, controlling considerably higher sums than initially invested. Therefore, even small price increases can result in a sizable profit/loss. The diversification of commodities also offered to investors' portfolios is also a large benefit.

Risks of Commodity Trading

Market volatility creates numerous trading opportunities, simultaneously generating risk as the market can move against the investor. The amount of leverage achievable is also a double-edged sword, as overextending yourself is possible. This means a slight price change can have disastrous consequences in a highly leveraged position. Specific risks are unique to the commodities market as it involves physical goods. A lack of storage facilities can cause large amounts of waste and price repercussions. Transportation issues such as shipping logistics and unforeseen accidents can cause price changes for certain commodities. Unexpected and unpredictable events cause price movements. Therefore, risk management is essential when trading commodities.

Long-term investments in the commodity market have fewer benefits than similar investments in the equity market, primarily due to the lack of dividend payments (share of the profit paid to shareholders). Therefore, holding onto commodities over a long period can sometimes fail to generate income for an investor.

How to Trade Commodities

FP Markets offers a wide array of commodity investments at a low-trading cost with fast execution. Opening an account is extremely simple. Fill out your details here, and you are ready to start trading. After setting up an account, worldwide leading commodity CFDs and ETFs are available to trade on both Metatrader 4 (MT4) and Metatrader 5 (MT5) trading platforms. Other investment opportunities in forex, stocks and bonds are also available.

The FP Market’s social trading tool also allows a new investor to follow an experienced trader's investments. This synchronises your transactions, simplifying a highly complicated market for a beginner. The professional trader's history is available, demonstrating a successful trading strategy to learn from.

A plethora of educational materials is also available on the FP Markets website for those looking to learn about the commodities market and other financial markets.

Put your fingerprint on the market through FP Markets.