A Guide to Commodity Trading Strategies

January 13, 2021 12:52 UTC

Commodities offer diversification for an investor’s portfolio, which reduces exposure to any one financial market and, therefore, is important in helping to manage risk. Traditionally, trading commodities was a more complicated affair and available only to professional traders. However, with advances in technology and, with it, online trading, commodity trading is more accessible than ever before.

In this article, we will explain what commodities are, tell you the different methods of trading available to you, explain how you can construct your own commodity trading strategies and much more!

Commodity Trading Strategies

What Are Commodities?

Commodities are either raw materials or agricultural products which are generally used as the “building blocks” for other goods or services. Therefore, the term commodity covers a vast range of goods, from sugar to crude oil, from coffee beans to gold.

Commodities of the same quality tend to be fungible with each other. In other words, they are interchangeable and of the same value to consumers.

For example, sugar produced in India will have the same value as sugar produced in Brazil. Provided the commodity is of the same quality, consumers will not usually distinguish between the two.  

How to Trade Commodities

Commodities are real, tangible assets which can be bought and sold. Naturally, buying and storing these physical assets in large enough quantities would be logistically difficult for the majority of traders who want to try to profit from them.

Luckily, there are many other ways for people to trade commodities without ever having to take physical ownership of the commodities in question. Below we have listed some of the most common methods available for trading commodities:

Each of these financial products comes with a list of their own advantages and disadvantages - so they provide you with a lot of choice about the best way for you to trade commodities.

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How to Create Commodity Trading Strategies

Given the vast array of goods included in the term ‘commodity and the different ways of trading them’, it is not possible to provide an all encompassing trading strategy that will be successful on every type of commodity. 

The type of trading strategy you use also depends on what type of trader you are. Commodity trading strategies that work for a day trader may not work for a swing trader.

Therefore, it is down to you to formulate a commodity trading strategy for the particular asset you intend to trade. However, we will provide you with some pointers to get you started!

Trading strategies are usually based on either technical analysis, fundamental analysis or a mixture of the two. In order to succeed in trading commodities, you should use some form of fundamental analysis, as prices will be influenced by global events. 

In the following section we will take a look at some of the factors which can influence the price of commodities, to help you get started with fundamentals.

What Affects the Price of Commodities?

Like all other goods, the prices of commodities are governed by the global levels of supply and demand. Decreases in supply and increases in demand both tend to put upwards pressure on prices. Conversely, prices will most likely fall when supply increases and/or demand increases. But what factors affect supply and demand for commodities?

Health of the Economy

The relationship between economic growth and commodities is more or less as you would expect. When the economy is growing strongly, people consume more of everything, driving up demand for commodities and in turn pushing up their prices.  This is true for commodities that are consumed, like rice and coffee; and for, so called, industrial commodities - commodities like copper and iron that are widely used in the manufacture of other products. 

The opposite is also true - when the economy is weak and people are earning less, or fear losing their jobs, then consumption of commodities like sugar and coffee will decline - as will manufacturing and, thus, the demand for industrial commodities.

Sugar Daily ChartDepicted: Admiral Markets MetaTrader 5 - Sugar.Raw Daily Chart. Date Range: 26 August 2019 - 29 October 2020. Date Captured: 29 October 2020. Past performance is not necessarily an indication of future performance.

There is one exception; a commodity whose demand is expected to stay the same or, sometimes, increase during times of economic turmoil. That commodity is gold. 

Gold is what is known as a safe haven asset. In other words, in times of financial turbulence, people will shy away from other investments and put their money into safe haven assets, such as gold. 

Gold Daily ChartDepicted: Admiral Markets MetaTrader 5 - Gold Daily Chart. Date Range: 9 September 2020 - 29 October 2020. Date Captured: 29 October 2020. Past performance is not necessarily an indication of future performance.

Weather 

For commodities which are agricultural products, also known as soft commodities, such as coffee and rice, adverse weather conditions can damage annual crops or even production facilities, denting supplies and increasing prices.

The opposite can also be true; sometimes ideal weather conditions result in bumper crops which go on to flood the markets and reduce prices. If a good has a relatively relatively fixed, or inelastic, demand, then the fall in prices can more than make up for the increase in crops. In other words, farmers can experience reduced income despite producing bumper crops!

Severe weather in the form of a coldspell or a heatwave can also affect the demand for heating, or air-conditioning, increasing, or decreasing, prices for oil and gas.

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Pests

The supply of agricultural commodities can also be affected by pests and diseases when these spread through crops.  

In January 2013, for example, there was a small spike in the spot price for coffee, caused by the spread of “coffee rust” across Central America. 

Currency Movements

Most commodities are produced outside the US but priced in US dollars for the international market. When the dollar rises, commodity prices tend to fall, when measured in dollars. There are two forces behind this.

First, when the dollar rises, commodities will become more expensive for non-dollar buyers. Consumers of these commodities will pull back on their consumption due to the higher price. This will reduce total demand and this decreased demand, in turn, will reduce prices.

The second force is transmitted through the supply-side.  Let’s look at an example.

When a country like Colombia is producing coffee, almost all of the costs of production will be in the local currency. When the dollar rises against the Colombian Peso, each dollar will be able to buy more coffee. A Colombian producer will receive fewer dollars for her coffee but her income will be unaffected when measured in the local currency.

The opposite of all this is also true - when the dollar falls, the price of dollar-denominated commodities will tend to rise.

Geopolitical Instability

Wars, strikes, demonstrations - anything that disrupts the production of a commodity, or its transportation, can lead to an increase in prices.  Sometimes just the threat of these events can have the same impact.

Earthquakes and Other Natural Disasters

Earthquakes, hurricanes, fires, floods and any other natural disaster can impact commodity prices if it disrupts production, production facilities or transportation.

The more concentrated the supply of a commodity is (copper in Chile or oil in the Middle East) the more sensitive it will be to many of the factors above.

Fundamental Trading Strategies

Now that you know some of the different factors that influence the price of commodities, you might decide to build commodity trading strategies out of this information.

For example, imagine you heard about adverse weather in the Colombian coffee region which was likely to ruin their harvest. From this information, you could deduce that this would most likely reduce the global supply of coffee and, therefore, raise the price. This might prompt you to take a long position in the coffee market.

What if new fiscal measures in the United States resulted in the dollar strengthening drastically. In commodity producing countries, such as Brazil and India who both produce sugar, wages and most other production costs will be priced in the local currency. This means that those costs of production will drop, when priced in US dollars. Because you know that this is likely to cause a subsequent drop in price, perhaps you will decide to take a short position in the sugar market.

There are many different scenarios where you can use information about what affects the price of commodities to your advantage when trading. A good way to keep up with information which might be important, is to use an economic calendar.

Technical Analysis Strategies

To some people, trading solely using fundamental analysis is not appealing. In this case it is possible to just be aware of any fundamental events which could affect your profits, but instead use commodity trading strategies which focus on technical analysis.

There are a whole range of technical indicators for traders to incorporate into their trading strategies and use to find trading signals for commodities.

One such indicator is the CCI (Commodity Channel Index). Despite its name its use is not limited solely to the commodities market! The CCI indicator is an oscillator which measures the strength behind a price movement.

WTI Daily ChartDepicted: Admiral Markets MetaTrader 5 - WTI Daily Chart. Date Range: 2 April 2020 - 29 October 2020. Date Captured: 29 October 2020. Past performance is not necessarily an indicator of future performance.

A very simple commodity trading strategy might choose to buy an asset once the indicator crosses above the +100 line and, conversely, sell when the indicator crosses below the -100 line.

Arabica Daily ChartDepicted: Admiral Markets MetaTrader 5 - Arabica Daily Chart. Date Range: 31 March 2020 - 29 October 2020. Date Captured: 29 October 2020. Past performance is not necessarily an indication of future performance.

Of course this is just one example of a simple strategy using technical indicators and not an endorsement. 

There are a whole range of other technical indicators which you could use to construct commodity trading strategies yourself.

Trading With Commodities

If you want to learn more about trading commodities, you can watch the webinar below, where professional trader Markus Gabel provides an in depth introduction to the subject!

Final Thoughts

You should now stand in good stead to start trading the commodity markets. Remember, once you have decided which commodity you want to trade, research what drives the global supply and demand of that commodity. Be aware of these drivers so you are not caught off guard whist trading.

It is always recomendable to practice any new commodity trading strategies on a demo account before taking it into the live markets. 

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If you are interested in exploring price charts of the different commodities listed above and testing different technical indicators, you will be pleased to learn that with Admiral Markets you can download MetaTrader 5 for free! 

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About Admiral Markets

Admiral Markets is a multi-award winning, globally regulated Forex and CFD broker, offering trading on over 8,000 financial instruments via the world's most popular trading platforms: MetaTrader 4 and MetaTrader 5. Start trading today!

This material does not contain and should not be construed as containing investment advice, investment recommendations, an offer of or solicitation for any transactions in financial instruments. Please note that such trading analysis is not a reliable indicator for any current or future performance, as circumstances may change over time. Before making any investment decisions, you should seek advice from independent financial advisors to ensure you understand the risks.

Roberto Rivero
Roberto Rivero
Financial Writer, Admirals, London

Roberto spent 11 years designing trading and decision-making systems for traders and fund managers and a further 13 years at S&P, working with professional investors. He has a BSc in Economics and an MBA and has been an active investor since the mid-1990s