How to Trade Commodities Guide
In this 'How to Trade Commodities Guide,' you will learn what commodities are, the different categories of commodities that are available to trade on, what influences the movement of commodity prices and how to start commodities trading in energy, metals, agriculture and grains.
Table of Contents
- What are Commodities?
- What are the Different Types of Commodities?
- The Different Methods of Commodities Trading
- Why Start Commodities Trading?
- Which Commodities Can You Trade Online?
- What Influences the Price of Commodities?
- Top Tips for Commodities Trading
- How to Start Trading Commodities in 4 Steps
- FAQs on Trading Commodities
What are Commodities?
What are commodities? A commodity is a basic good or raw material that is used in commerce. These individual commodities are usually the building blocks for more complex goods or services. For example, sugar and cocoa are both soft commodities that are the building blocks of a chocolate bar.
What separates commodities from other goods is the fact they are interchangeable and standardised, with their values set by the relevant commodity exchange. This means that no matter who produces a commodity, or where it is produced, two equivalent units of the commodity will, more or less, have the same quality and price. So 500 grams of sugar will have the same value whether it is produced in India, Brazil or Thailand.
In the past physical trading commodity took place. However, nowadays, most will perform commodities trading online using a broker.
What are the Different Types of Commodities?
Commodities are either extracted, grown or produced. There are four main categories that define the commodity market:
- Energy Commodities: This includes petrol products like oil and gas.
- Agricultural Commodities: This includes raw goods such as sugar, cotton, coffee beans, etc.
- Metal Commodities: This includes precious metals such as gold, silver and platinum, but also base metals like copper.
- Livestock Commodities: This includes pork bellies, live cattle and general livestock, as well as meat commodities.
- Crude Oil: Crude oil is a popular commodity for trading because it can be very volatile. With the top producers of crude oil including Saudi Arabia, the US, Russia and China, this is a market that is very reactive to political events. Demand for this commodity is also high, because crude oil is used for transportation fuel, the production of plastics, synthetic textiles, fertilisers, computers, cosmetics and more. The major oil benchmarks are WTI and Brent Crude Oil
- Natural Gas: This commodity has a range of industrial, residential and commercial uses, including generating electricity. The top natural gas producers are Gazprom, Royal Dutch Shell, ExxonMobil, PetroChina and BP.
- Coffee: Coffee is one of the world's favourite beverages with more than 2.25 billion cups being consumed a day. It is also one of the world's largest commodity markets, being the second most-traded market after petroleum.
- Sugar: Both white and raw sugar are traded as commodities. While most of us think of sugar as a sweetener, it also plays a key role in the production of ethanol.
- Gold: Gold is another popular commodity. Known as a safe haven asset, gold is typically where investors put their money when markets are in turmoil. This means gold is often inversely correlated with the US dollar.
- Silver: While gold is the most popular metal commodity for trading, silver also has some advantages. One of these is that the silver price tends to move a lot faster than the gold price, making it attractive for active commodity traders. Gold, on the other hand, has a higher value and is often seen as attractive for longer-term investors.
- Copper: Copper benefits from consistently high demand, being used for electrical equipment, engineering, plumbing and cooking utensils. Its price is considered to be a reliable barometer of the global economy, so investing in copper is a way to take a bullish stance on world GDP.
You will also encounter terms such as hard commodities and soft commodities trading.
- Hard commodities are mostly those that are mined (gold, oil, etc).
- Soft commodities are agricultural or animals (wheat, soybeans, pork, sugar, etc.).
What are tradable commodities? As you can imagine, some commodities are traded more actively than others.
For example, the Feeder Cattle market may only involve the farmer and the distribution company of the livestock - thereby not producing that much trading activity. However, a market like oil will involve public drilling companies like BP and Shell, airlines who are actively involved in buying and selling oil to keep their fuel costs in check and, of course, speculators.
The Different Methods of Commodities Trading
There are a number of ways you can trade commodities: investing in the physical commodity itself, trading commodity futures, trading commodity options, trading commodity ETFs, trading commodity shares and trading CFDs on commodities. We will outline each of these options below.
Invest in physical commodities
One way to invest in commodities is to go directly to the source and purchase the goods themselves (e.g. purchase oil, gold or sugar directly). Over time, if prices rise, you could find a buyer and pocket the difference in profit.
But is it really that feasible for you to go and find a producer and seller of oil, or sugar, to buy the goods from? You would then have to find a buyer for your goods as well. And you will have to store your goods, as commodities are physical products!
Producers of sugar only sell in quantities of 112,000 pounds. That's about eight and a half times the weight of an elephant. Could you store that much? It's quite unlikely! Also, let's not forget the fact that volatility in commodities tends to be higher than with stocks and bonds, as there are more supply and demand issues affecting the price.
In addition to physical storage space, you would need to consider other storage factors. For example, if you were to buy precious metals (fortunately, these are available in smaller quantities than sugar), you would need a secure storage facility, which increases the cost and complexity of your investment.
Trade commodity futures
As we discussed earlier, futures are contracts where a seller agrees to sell a fixed quantity of a certain commodity at a fixed price on a particular day in the future to a buyer.
Historically, at the expiration of the futures contract, the commodity would change hands from the buyer to the seller. However, today many traders use futures as a vehicle for speculating on commodity prices and have no intention of taking ownership of the actual commodity once the contract expires.
Simply, if the commodity price rises between the purchase date of the contract and the expiration date of the contract, the trader can sell the futures contract at a profit. If the price falls, the trader will make a loss.
One of the benefits of trading commodity futures is the use of leverage, which allows traders to make a larger trade than what they could purchase outright with their available funds. For instance, if a futures contract is offered with leverage of 1:10, this means that for each dollar the trader is willing to invest, they can access $10 worth of the commodity in question.
This can amplify trading profits, but can also amplify trading losses. Learn more about leverage here.
While leverage can make futures trading attractive to new traders, futures trading is highly complex as there are many factors to take into consideration when evaluating market pricing and predicting the direction in which it will move. For instance, along with looking at the current price of a commodity, it is also important to consider the cost of storage and interest rates and how they might influence commodity prices.
Source: TradingView. Please note: Past performance is not a reliable indicator of future performance or results.
Like futures, options are another type of derivative that allows you to trade on the changing value of a commodity without having to purchase the commodity outright. Options can also benefit from leverage.
There are two types of options contracts - calls and puts.
The owner of a call option has the right but not the obligation to buy a commodity futures contract at a set price (the strike price) on or before a certain date (the expiration date). The owner of a put option, on the other hand, has the right but not the obligation to sell a futures contract at the strike price on or before the expiration date.
If the price of the future becomes higher than the strike price, a call option can be sold for a profit. For a put option, the reverse is true - the price of the future needs to fall below the strike price.
This means options traders not only need to consider how market pricing will change in their strategy, but also the timing of those changes.
An ETF, or an exchange-traded fund, is a fund that invests in a group of financial assets. As a trader, you can invest in these funds via a broker or on a stock exchange.
ETFs are most well-known for containing bundles of stocks, however, some ETFs invest in physical commodities like gold bullion, while others invest in commodity futures or options.
With this in mind, the risks involved with trading ETFs mirror the risks of the assets they contain. ETFs that invest in physical commodities will carry similar risks to investing in physical commodities, while those that invest in futures carry similar risks to buying futures directly.
One of the main advantages of investing in commodity ETFs is the diversity that comes with investing in a range of assets via a fund, rather than picking individual assets to invest in. However, this can also mean you miss out on large movements that take place in individual commodities.
By 'commodity shares', we mean the shares of companies that produce commodities. The theory is that these companies' revenues are based on the price of the commodity they are selling - if the price of the commodity increases, so too should a company's revenues and its share price.
The challenge with this approach is that there are risks to a commodity producer's share price in addition to the factors that can influence commodity prices. These include:
- Market competition
- Costs of doing business
- Interest rates
- Local economy performance
- Price/earnings growth/contraction
Like options and futures, CFDs (Contracts for Difference) are another derivative instrument that can be used to trade commodities.
CFDs allow traders to speculate on the changing prices of commodities, and other assets, without ever owning the commodity in question. They were originally developed in the early 1990s in London, by two investment bankers at UBS Warburg.
Essentially, a CFD is a contract between two parties - the trader and the broker. At the end of the contract, the two parties exchange the difference between the price of the commodity at the time they entered into the contract and the price of the commodity at the end.
So if you opened a long (buy) CFD trade on gold when gold was priced at $1,525, and you closed the trade after the price of gold rose to $1,550, you would make a profit on the difference in the gold price, or $25. If the price fell to $1,500, you would make a loss of $25. In simple terms, the trader is paying the difference between the opening and closing price of the commodity they are trading.
The simplicity of entering and exiting positions, compared to other trading vehicles like options and futures, is just one reason why trading commodity CFDs is very popular.
Commodity CFD trading example
Let's look at a commodity example trade. You think the price of Brent crude oil is going to fall, so you decide to open a sell, or short, trade. Essentially, you would open the trade at one price and if the price fell, you would close the trade and pocket the difference as profit.
In this example, the market price of Brent crude oil is $72.22 per barrel. One lot is the equivalent of 100 barrels of Brent Crude oil. Therefore, the value of one lot of Brent would be $7,222.
The available financial leverage you have is 1:10, so to open a trade on one lot, or $7,222, of Brent crude oil, you would need to have $722 in your trading account. ($7,222/10 = $722).
If you opened a short commodity trade at $72.22 and then closed it at $53.46, the difference between the opening price of the trade and the closing price of the trade would be $18.76.
To figure out your profit, you would need to multiply that price difference by the size of the trade, and by the value of a one-point movement. Both the contract size and point value vary for different commodities, so it's important to be aware of this in advance.
In this case, your trade was one lot or 100 barrels of the commodity Brent crude oil. This gives us:
(72.22 - 53.46) x 100 = $1,876
18.76 x 100 x $1 = $1,876
So you would make a profit on the trade of $1,876! Just remember that if the price of Brent had gone up rather than down, you would have made a loss.
You can learn more about this formula in our beginner's guide to CFD trading. The formula for calculating your profit/loss is the same for every commodity - price difference x contract size x value of a one-point movement. Just remember that the contract size and point movement values are different for each instrument, so need to be considered in your trading strategy.
You can also use the Admirals Trading Calculator which will help you with risk management calculations.
Commodity trading costs
It's important to keep in mind that your trading profit isn't simply the difference between the opening and closing price of the trade - you also need to consider the costs of trading.
When trading commodity CFDs, there are three potential costs to consider:
- Spreads: The spread is the difference between the bid (buy) and ask (sell) prices of a financial instrument. For example, if the bid price of the Gold is 1491.58, and the ask price is 1491.78, that is a difference of 0.20. For a trade to be profitable, it will need to cross this spread.
- Swaps: If you keep trades open overnight, a fee or adjustment gets charged.
- Commissions: Some instruments are also charged a commission for opening and closing trades. But some accounts and commodity markets are available to trade with zero commission.
So, to calculate your commodity trading profit, you'll need to subtract the cost of trading from the formula above. This is a point that new traders often forget to consider before making their first trade. An effective trading strategy takes this into account and helps you avoid entering the wrong trades.
Why Start Commodities Trading?
While there are a range of reasons to start trading commodities, there are three main reasons that make commodities an interesting investment for today's traders. These are the growing global population, inflation hedging and portfolio diversification.
Global population growth has exploded since the beginning of the twentieth century, with the global population now reaching 7.7 billion. While the annual growth rate is slowing, it's still sitting around 1% a year, which means that the number will continue to climb.
Population growth then creates demand for infrastructure, which could have a significant impact on the demand for both metal and energy commodities. In addition, more people means there are more mouths to feed, which will affect the demand for agricultural commodities.
Ultimately, more people lead to more demand, which means that commodity prices are likely to continue to increase over the long term.
Inflation is the rate at which prices increase which means that today's money will have less purchasing power in the future. In terms of commodities, it means it will cost more dollars to purchase the same amount of a given commodity in the future.
By investing in commodities directly, however, savvy traders can protect themselves from these price increases, and could potentially benefit from selling the commodities for a higher price in the future.
Many investors do not have a diversified portfolio. In many Western countries, the bulk of a household's net worth is tied up in their property. Meanwhile, those who do invest tend to stick to stocks or bonds.
The issue with this is that if the market in which you are investing has a downturn (e.g. if the real estate or stock market crashes), your portfolio will take a significant hit. On the other hand, if you have invested in a range of assets the individual investments in falling markets will be affected, but the overall portfolio will be insulated, as other markets will remain stable or might even climb.
Commodities are one asset class that can be added to your portfolio to create diversification and better manage risk.
Which Commodities Can You Trade Online?
With Admirals you can trade 29 commodities online using CFDs (contracts for difference). This allows you to speculate on the price direction of a commodity market without owning the underlying asset. CFDs allow you to speculate on rising and falling prices by trading long and short using leverage.
Learn how to trade the financial markets in the free Zero to Hero trading course:
What Influences the Price of Commodities?
Each individual commodity has unique factors that affect its price. Huge price swings in the commodity market can occur when the scarcity or abundance of a commodity is threatened. Overall the biggest influence across all commodities boils down to changes in supply and demand, however, other elements like the US dollar, substitution and weather can also have an impact.
The supply of a commodity can be influenced by a multitude of factors, such as government intervention, weather, war, and so on.
For example, on 14 September 2019, a swarm of explosive drones attacked the world's biggest oil processing plant in Saudi Arabia, reducing global oil production by 5 million barrels a day. This accounts for nearly half of Saudi Arabia's current output and 5% of global production. The event triggered a record surge in oil prices.
When the market opened on 16 September, Brent Crude Oil spiked from 60.42 on the evening of 13 September to 72.19 at the market open on 16 September - a jump of 19.4%. Over the same period, WTI Crude Oil leapt 15.5% - from 54.79 to 63.28.
This surge in price was triggered because less oil was available in the marketplace but demand had remained the same as before. Therefore, commercials and institutions scrambled to get their hands on whatever oil was left. This type of 'scarcity' typically leads to price increases.
When it comes to commodities trading, it pays to remember that the supply of energy commodities is mostly affected by government policy (such as economic sanctions) and Middle Eastern tensions, as Saudi Arabia has one-fifth of the world's proven oil reserves.
Commodities can be also very volatile and trend in one direction for a long time.
A good example of that is how in 2020 West Texas Intermediate (Crude Oil) price went from nearly 65 USD per barrel to negative in 4 months. This was caused by many factors falling together at the same time, but mainly it was caused due to decreased demand for oil as the coronavirus hit the global economy and therefore the majority of global transport was stopped.
At the same time, oil producers continued to produce nearly record levels of oil into the global market even as analysts warned that the impact of the coronavirus will decrease demand significantly.
The combination of these factors led to global oil storage being full as there was nowhere to store it. Simply put, in order to get rid of the oil, the oil sellers had to pay buyers to empty their storage.
Why did the producers keep oil production up? Oil wells can't simply be turned off and on. It costs human resources and a significant amount of money to shut them down and even more resources to start them again. Oil producers have to keep production flowing, even if they are operating at a loss and for a short period of time, they were willing to pay in order for distribution companies to take oil.
Below you can see CRUDOIL chart trending down from 65 USD per barrel to negative territory for the first time in history.
The market went on to rally strongly afterwards as the global economy picked up, airline travel resumed and the demand for oil increased. The volatility in commodity markets such as oil can be a good and bad thing. Commodity traders need price movement to turn a profit. However, too much volatility can be hard to analyse and stay on top of.
The demand for a commodity can also be influenced by numerous factors, such as changes in consumer habits and the health of the economy. For example, many people's habits around consuming sugar have changed. People are actively trying to consume less sugar. If enough people see it through, then demand shrinks accordingly. In the chart below, we can see sugar prices for an extended period:
The yellow boxes in the chart above highlight the sharp declines in the price of sugar beginning in 2010. However, there was a move higher between September 2015 to September 2016, due to concerns over a global shortage. This was caused by a supply disruption to a Brazilian cane crop (which is the world's largest producer), which helped sugar to become 'scarce', and, therefore, caused prices to move higher.
However, in this particular instance, whilst a change in weather caused sugar prices to push higher during that period of time, the bigger issue of demand played out in the end, sending prices back down.
Commodities Trading and the US Dollar Relationship
Along with supply and demand, the behaviour of the US dollar can also influence commodity prices.
The US dollar is the world's reserve currency and, in international markets, commodities are priced in USD. This means that the prices of commodities are directly linked to the value of the dollar against foreign currencies. For example, if the value of the dollar drops against other currencies, it takes more dollars to purchase commodities than it does when the dollar is valued more highly.
In addition, gold is seen as a safe-haven asset, and is often where investors turn when the value of the USD goes down, particularly in times of economic turmoil. So gold not only benefits from being priced higher in USD, but it also benefits from further investment, which can lead to larger jumps than traders might see in other commodities.
Substitution simply means that markets will look for cheaper alternatives where possible. As a particular commodity becomes more expensive, buyers will look for cheaper options. If they find a suitable alternative, they will start purchasing that, which reduces the demand for the original commodity and can result in a price decrease.
One example is copper, which is used in a range of industrial applications. As the price of copper has increased, many manufacturers have started using aluminium instead.
Commodities Trading & the Weather
Weather can also influence commodity prices. In particular, abnormal or unexpected weather changes like extreme rain or drought can have a significant impact on agricultural commodities. Simply put, commodities like cocoa, coffee and orange juice are harvested and grown, and therefore need consistent weather cycles.
Having said that, the weather can also influence energy commodity prices, as severe winters increase the demand for heating, which in turn increases the demand for heating oil and natural gas. The same goes for extremely warm weather, which increases the need for air conditioning. This raises the demand for the commodities involved in electricity production, like natural gas and coal.
Top Tips for Commodities Trading
Here are four things to take into consideration to learn how to trade commodities.
1. Get educated
A demo trading account is another good way to learn how to trade - particularly when it comes to the mechanics of opening and closing trades and seeing how the markets work. However, a demo account can't teach you about your trading psychology, or how you manage money, so it's important to make the leap to a live trading account when you feel ready.
2. Analyse the commodity market
To make successful commodity trades, it's important to understand the reasons you are making those trades. Why do you believe a commodity is going to go up or down?
Most commodity analysis falls into two categories: fundamental analysis and technical analysis.
Fundamental analysis focuses on analysing economic factors that could influence the price of different commodities - particularly those that relate to supply and demand, as we discussed earlier. This might mean paying attention to:
- Macroeconomic data, like trends in GDP, unemployment and retail sales. These are all clues about the strength of an economy and is often related to the strength or weakness of industrial commodity prices.
- The strength of the end markets of different commodities, will influence demand for those commodities.
- Level of supply, which can be assessed in reports like the USDA's Cattle on Feed report. This report indicates the future supply of cattle coming onto the market and can offer clues about beef prices.
- Market cycles, such as whether the markets are in a bull or bear cycle. This involves long-term analysis of market trends to make judgements about what's happening today.
- Changing policies from large economies and how they might influence commodity demand.
As you can see, there are a lot of things to keep in mind! And, if you are not a full-time trader with a team of research analysts at your disposal, it may prove to be difficult to track weather formations and government policy.
That's why many traders also use technical analysis to help with their trading decisions. So what is a technical analysis of the commodity market? It is simply looking at patterns and indicators on a price chart for a particular commodity, for clues on its future direction.
3. Manage your risk
Many traders consider trading commodities - particularly commodity CFDs - because access to leverage means they can trade large positions with a relatively small deposit, and amplify their profits as a result.
However, it's important to remember that leverage magnifies losses to the same extent as profits, which means it increases the risk of this type of trading - particularly when compared with traditional investing.
This is why risk management is essential. There are a number of ways you can manage risk, and some common ones include:
- Effective money management: Don't trade with money you can't afford to lose.
- Sensible position sizing: A general rule of thumb is that a single trade shouldn't risk more than 2% of your account balance. So if you have $1,000 in your account, you wouldn't want to risk more than $20 per trade. If your account balance increases or decreases, so too will your maximum risk per trade.
- Using stop losses and take profits: Stop losses and take profits are automatic levels you set at which your trade will close, meaning you don't need to manually close it. A stop loss is designed to prevent you from losing more than expected - if an instrument moves too far against you, the trade will close. A take profit is the opposite - a trade will close automatically once it has achieved a certain level of profit.
- Following a clear strategy: Some new commodity traders open a number of random trades and hope one of them will work. Worse, if they lose, they might open larger and larger trades in the hope of recouping their losses in one big win. Instead, you should always follow a strategy - one that defines how much you will risk, when you will open trades and when you will close them.
Managing risk is an essential aspect of any successful trading strategy. By employing these methods in your trading strategy you can avoid taking on losses that you can't afford and finding yourself in a difficult situation. Often, new traders suspect it won't be hard to exit a trade when it's looking bad and to make other reasonable decisions as they enter new positions.
However, a trader's emotions can overpower their decision-making quite easily when they are in the middle of a trade. The power of their emotions is difficult to imagine when they are in a calm and collected state of mind before they have entered their first trade.
The best way to avoid making mistakes is by sticking to a risk management strategy.
4. Diversify your portfolio with commodities
Do you know the expression 'Don't put all your eggs in one basket?' It is very relevant when investing - you don't want to put all of your funds into one asset, or one market, because if it goes down you could lose everything.
Instead, it's important to build a portfolio that tracks a wide range of assets, including commodities. So you might have a portfolio that includes:
- Metal commodities like gold and silver
- Energy commodities like natural gas and crude oil
- Agricultural commodities like sugar and coffee
- Shares from a range of markets - the US, Europe, Asia-Pacific
- Indices, representing entire markets
How to Start Trading Commodities in 4 Steps
- Open a demo or live trading account with Admirals.
- In your dashboard, click on Trade next to your trading account to open the web platform.
- Search for your commodity in the search box to view the live price chart.
- Click on Create New Order to open a trading ticket to buy or sell commodities.
One of the best ways to learn how to trade commodities is through the use of a demo practice trading account. This account allows you to buy and sell in a virtual environment until you are ready to go live.
A demo practice trading account can help you to master your skillset while testing the broker's services and products.
FAQs on Trading Commodities
What are commodities in trading?
Commodities that can be traded include coffee, sugar, cocoa, gold, silver, copper, oil and many others. They are the basic materials used to build other products such as food, cars, buildings, etc.
How do I trade in commodities?
You can now trade commodities online using a laptop, internet connection and broker. With CFDs (contracts for difference), you can speculate on the price direction of different commodities without owning the underlying asset. They also allow you to trade long and short so you can profit from rising and falling markets.
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