How to Start Commodities Trading
Reading time: 14 minutes
In this article you will discover: What commodities are, the four main categories of commodities, how to invest in commodities, how to trade commodities via CFDs starting today, the benefits of trading commodity CFDs, what drives commodity prices, how to learn commodities trading risk free, and more!
Did you know that commodities trading dates back to ancient civilisation itself? As far back as 4500 and 4000 BCE in Sumer (now modern day Iraq), there was a commodity market. Locals would use clay tokens as a medium of exchange for goats. Even in 17th century Japan, rice merchants used to sell their stores of rice by selling 'rice tickets' (just like clay tokens) to willing buyers. However, the global commodities market, and commodity trading itself really kicked off when the Chicago Board of Trade was setup in 1848. Now it's one of the most popular types of markets to trade on, from commercials, institutions, and speculators alike.
What are Commodities?
Before we look at the makeup of commodities, let's first look at what is a commodity and what does commodity mean. A commodity is simply 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 commodities that are the building blocks of a chocolate bar.
However, what separates commodities from other goods is the fact they are interchangeable and standardised. This means that no matter who or where a commodity is produced, two equivalent units of the commodity will, more or less, have the same quality and price.
So what are the different types of commodities that are used in commerce? Generally speaking, commodities are either extracted, grown, or produced. In fact, you probably have quite a few commodities for breakfast. For example, some of the most basic types of commodities are sugar, cocoa and arabica coffee. There are plenty more within the commodity market, so let's take a look at these and the four main categories that define commodities:
The 4 Categories of the Commodity Market
Within commodities trading, there are four main categories that define the commodity market, and to which each individual commodity is tradeable. These are:
- Agricultural Commodities: This includes raw goods such as sugar, cotton, coffee beans, etc.
- Energy Commodities: This includes petro products like oil and gas.
- 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.
This is just a small selection of different commodities within the four main categories of the commodity market. Before we look at how to learn commodities trading, and how to trade commodities, it is important to understand that most traders and investors stick to the most traded commodities, or the most liquid within the financial markets.
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 stock - thereby not producing that much trading activity. In fact, according to the Chicago Mercantile Exchange, the total trading volume of Feeder Cattle for November 2018 was just 1,365. This number represents how many contracts, for the right to buy or sell feeder cattle, have been bought and sold.
However, a market like oil will involve public drilling companies, government backed drilling companies, service 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. According to the Chicago Mercantile Exchange, the total trading volume of Crude Oil for December 2018 was 866,628 - a huge difference from Feeder Cattle.
With Admiral Markets you have access via CFDs to sixteen of the largest commodities traded in the commodity market. Here is a list of the commodity CFDs available:
- Agricultural Commodities
- Arabica Coffee
- Orange Juice
- Robusta Coffee
- Sugar Raw
- Sugar White
- Energy Commodities
- Brent Crude Oil
- WTI Crude Oil
- Natural Gas
- Metal Commodities
So now we have a list of commodities you can trade CFDs on, how how does one start investing in commodities? Let's have a look:
How to Invest in Commodities
One way to invest in commodities is to go directly to the source and purchase your goods. Over time, if prices rise, you could go out and find a seller and maybe pocket the difference in profit. Of course, 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. Oh, and let's not forget that 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 stocks and bonds, as there are more supply and demand issues affecting the price (something we will discuss in more detail further below).
Before we look at what influences prices in the commodities market, is there a another way to invest in commodities? Yes, there is. One such way is to trade commodities through a broker. So let's take a look at how to trade commodities through a broker, and why it is more popular.
How to Trade Commodities
Commodities trading has evolved hugely since the days of giving clay tokens for goats. There have been a variety of products that institutions and investors have used to trade commodities in the past. For example, commodity futures contracts allow traders to gain exposure to the fluctuations in commodity prices, without taking physical delivery of the product via a broker.
In essence, a trader will trade contracts of the future delivery of a commodity. The trader pays for the contract at the beginning of the purchase. If prices have risen between the purchase date and the expiration date, the trader will then profit. If prices have fallen, the trader will lose money.
However, even this type of trading can get hugely complicated. Different futures markets have disparate delivery dates, and the sizes of purchases all vary as well. This is why many people involved in commodity trading have turned to CFD trading through a broker.
Trading Commodity CFDs
A CFD (or Contract for Difference), allows a trader to speculate on the rise and fall of a market, without ever owning the product. 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.
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, is just one reason why trading commodity CFDs is very popular. That's not to say it's easy, but there are certain benefits, such as:
- Leverage - a retail trader can trade positions twenty times their balance. A professional trader can trade positions five hundred times their balance.
- 24h/5d - traders can trade twenty fours a day, five days a week, accessing opportunities from a variety of commodities all around the world.
- Zero commission - traders can trade with zero commissions, and can start with just 200 euros in their account.
- Profit from a rising and falling market - if you get the direction right of course! Otherwise, losses can occur.
However, there are even more benefits to trading commodity CFDs with Admiral Markets, such as:
- Negative Balance Protection policy
- Spreads from 0 pips
- Free market news and analysis provided by the Dow Jones
- Access to MetaTrader 4 and MetaTrader 5
Having the right platform and a trusted broker are hugely important aspects of trading. However, with commodities trading, it is also important to understand what drives commodity prices and how can they be traded, so let's take look:
What Drives Commodity Prices?
Each individual commodity has unique factors that affects 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.
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 6 August 2018, US President Donald Trump re-imposed economic sanctions on Iran. This meant that Iran's oil, which is the fourth largest reserve in the world, was off limits for purchase.
The result? Less oil was available in the marketplace. But because demand had not changed, commercials and institutions scrambled to get their hands on whatever oil was left. This 'scarcity' typically leads to a price increase. In the chart below, we can see that the market rallied up the next day on 7 August 2018 and went over 900 points higher (highlighted in the yellow box) before falling back down.
Source: Admiral Markets MT5 Supreme Edition - WTI Daily Chart - Data range: 25 May 2017 to 11 November 2018 - Performed on 11 November 2018 at 7:52 PM GMT
When it comes to commodities trading, it pays to remember that the supply of energy commodities are mostly affected by government policy (such as economic sanctions) and Middle Eastern tensions as Saudi Arabia have one fifth of the world's proven oil reserves.
Influences on the supply of agricultural commodities are mostly affected by abnormal weather patterns like extreme rain or drought. That's because most of these commodities like cocoa, coffee, and orange juice are harvested and grown, and therefore need consistent weather cycles for crops to grow.
The demand of a commodity can be influenced by a multitude of factors, such as changes in consumer habits and the health of the economy. For example, many peoples' 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:
Source: Admiral Markets MT5 Supreme Edition - Sugar.White Daily Chart - Data range: 27 March 2005 to 11 November 2018 - Performed on 11 November 2018 at 8:31 PM GMT
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. In fact, it was because of a supply disruption to a Brazilian cane crop (which is the world's largest producer), that helped sugar to become 'scarce', and thereby 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. This is one reason why trading commodity CFDs could have been helpful in this 'sugar' scenario. With commodity CFDs you can profit from a falling market, as well as a rising market - as long as you get the direction right.
So, now you know a little more about the factors that drive commodity prices, as well as a popular vehicle to trade commodities from, how can you start commodities trading risk free today? Let's take a look!
How to Learn Commodities Trading Risk Free
In the last section we covered the factors that drive commodity prices. However, 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, and practice their ideas on a demo trading account. So what is 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.
For example, one tool that is popular amongst traders is moving averages, as they help determine the overall direction, or trend of a market. Essentially, they calculate a user-defined number of previous closing prices to find the 'average' price of the market. This line is then plotted on the chart so the trader can see the average trend of prices, historically.
Source: Admiral Markets MT5 Supreme Edition - GOLD Daily Chart - Data range: 7 March 2018 to 11 November 2018 - Performed on 11 November 2018 at 9:06 PM GMT
In the chart above, the red moving average line represents the average of the last fifty bars. The green line represents the average of the last one hundred bars. What you'll notice is that when the price bars are below the fifty moving average, and that is below the one hundred moving average, prices tend to accelerate lower. This is a common occurrence in most markets exhibiting a similar behaviour. This is just one type of free indicator, among many, available to use on the Admiral Markets MT5 platform.
In this instance, we can say that sellers are in control of the gold market. At this stage, you may not know the fundamental reason causing the weakness. However, using other technical analysis tools can help to stack the overall probability in your favour. For example, you could use price action patterns to analyse the behaviour of buyers and sellers within a commodity market, for clues on what could happen next.
Source: Admiral Markets MT5 Supreme Edition - GOLD Daily Chart - Data range: 7 March 2018 to 11 November 2018 - Performed on 11 November 2018 at 9:18 PM GMT
In the example provided above, the yellow boxes highlight different examples of pin bar reversal patterns that are widely used by traders. The pattern shows buyers trying to push the market higher, but then allowing sellers to step in and take control of the market, pushing it back down, in line with the overall trend. Some of the moves lower only last a few days, and some a few weeks.
With a demo account, you can practice identifying these types of setups, as well as other technical analysis tools, until you find the right approach for you. Of course, the right approach isn't always going to be a 100% winner. Losing trades is simply part of the game. That's why starting commodities trading risk free will with a demo account also help you to develop the correct mindset of a trader.risks.