Commodity Trading Explained: Where to Start?

ByJulija A.
June 09, 2022

In today's economy, it is crucial to diversify your investments. One way to do this is to start trading commodities. But what are commodities? And how do you trade them? 

In this guide, we will explain everything you need to know about commodity trading. We will cover what commodities are, check into some different types available for trading, and give you a few tips on how to get started in the commodity market. So if you're interested in learning more about this exciting investment opportunity, keep reading!

What is a Commodity?

A commodity is a good or service produced and traded on the market. The market price of any item is determined by supply and demand, and it fluctuates based on market conditions. 

Commodities can be either physical or financial. Physical ones include natural resources like oil and gold, while financial ones are stocks, bonds, and currencies. 

If you wish to invest in commodities, you can do that on various exchanges, including The New York Stock Exchange and The London Metal Exchange.

Commodities are an essential part of the global economy, and they play an important role in our everyday lives. For example, the price of oil affects the cost of gasoline, which impacts how much we pay to fill up our cars. 

The price of gold affects the jewelry industry, and the cost of coffee beans affects how much we pay for our morning cup of joy. By understanding the commodity markets, you can gain insights into the global economy and make better-informed investment decisions.

Types of Commodities

There are many different types of commodities, but they can broadly be divided into two main categories: hard and soft commodities. So let's see what the difference between the two is.

Hard Commodities

Hard commodities are those that must be mined or extracted from the earth. The most common ones include precious metals like gold and silver and energy sources like oil and natural gas. 

Unlike soft commodities, which can be grown or produced, hard commodities are limited in supply and are thus subject to higher prices when demand is high. 

While the prices of hard commodities can fluctuate dramatically in response to global events, they generally trend upwards over the long term due to inflation and population growth. 

As a result, hard commodities are often seen as a safe investment during periods of economic uncertainty.

So, if you're thinking about investing in commodities and looking for stability, hard commodities might be the way to go.

Soft Commodities

Soft commodities are agricultural products grown and harvested on an annual basis. Unlike hard commodities, which are mined from the ground, soft commodities are highly perishable and subject to the vagaries of weather and climate. 

The most common soft commodities include wheat, corn, soybeans, rice, sugar, coffee, and cocoa. 

Because of their perishable nature, soft commodities must be stored and transported under controlled conditions to maintain their quality. That is why their price can be volatile, rising and falling in response to changes in supply and demand. 

Nevertheless, soft commodities play an important role in the global economy, providing essential foodstuffs for humans and animals.

How to Trade Commodities

If you're into this type of trading, there are a few things you need to know. First, you must choose a broker - a financial professional who will execute trades on your behalf. 

You can either choose a full-service broker, who will provide you with research and advice, or a discount broker, who will simply execute trades at your request. 

Once you've picked a commodity broker, you need to open a brokerage account. This account will hold your investments and allow you to trade on the commodities markets. 

To open a brokerage account, you will need to provide personal information and documents like your passport or driver's license. You will also need to deposit money into your account to use it to buy and sell commodities.

So there you have it: a brief guide on how to invest in commodities. Now that you know the basics, you can start thinking about how to make money in the commodities markets. 

But remember, like any investment, this type of trading comes with risks. So be sure to do your research and understand the commodity market before you start trading. With that in mind, let’s look at some ways to do commodity trading.

Ways to Trade Commodities

There are a few ways to trade commodities. Here are the most common ones.

Futures Contracts

A futures contract is an agreement to buy or sell a commodity at a set price on a future date. Traders often use futures contracts to speculate on the direction of prices. So, if you wish to learn how to trade commodities, futures contracts are a good place to start.

For example, if a trader believes that the price of crude oil will rise in the future, they might buy some now and make a futures contract to sell it at a later date. If the price of crude oil does indeed rise, the trader can then sell the contract for a profit. However, if the oil prices fall, they will lose money.

ETFs

Another way to trade commodities is through ETFs or exchange-traded funds. ETFs track the performance of a particular commodity or a group of them. Some ETFs track gold, silver, and other precious metals, while others follow the performance of agricultural commodities like wheat, corn, and soybeans.

Investors can buy and sell ETFs on the New York Stock Exchange or any other major exchange and reap the benefits of price movements.

So, if you want to trade commodities online, ETFs are an excellent starting point.

Options Contracts

An options contract is an agreement between two parties to buy or sell a commodity at a set price on or before a specific date. Options contracts give the holder the right, but not the obligation, to buy or sell the underlying commodity.

If you believe that the price of gold will rise next month, you could buy a gold call option. This gives you the right to buy gold at a set price in the future. If the price of gold does indeed rise, you can exercise your option and buy gold at a lower price.

However, if the price of gold falls, you can simply let your option expire, and you will not have it. Commodity traders often use options contracts to hedge against losses on the underlying commodity.

Commodity Pools and Managed Futures

A commodity pool is a fund that pools together money from different investors and invests it in commodities. Commodity pools are managed by professional traders who trade on their behalf and often buy and sell futures contracts.

In a commodity pool, investors all share in the profits and the losses.

Managed futures are similar to commodity pools, except they are usually run by large financial institutions. Managed futures funds use complex trading strategies and often trade on multiple commodity markets.

Commodity Trading Strategies

There are several different strategies that traders use to trade commodities. Some common ones include:

Trend following: This involves purchasing commodities that are rising in price and selling those that are falling. 

Contrarian investing: As its name suggests, contrarian investing means taking the opposite position from most investors. For example, if most investors believe that the price of gold will rise, a contrarian investor might sell gold now. 

Scalping: With scalping, traders make small but frequent profits by buying and selling commodities multiple times throughout the day. 

Momentum investing: This refers to buying commodities that show strong price momentum and selling those that do not. 

Value investing: This strategy means you are purchasing undervalued commodities and selling those that are overvalued. 

Arbitrage: This is a type of trading in which traders take advantage of price discrepancies in different financial markets. For example, if the price of gold is higher in one commodity market than in another, a trader will buy it where it’s more affordable and then sell it elsewhere at a profit.

Final Thoughts

Commodity trading can be a complex and risky business. However, it can also be a great way to make money. Now that you know how commodities trading works, understand the risks and have a solid trading strategy, you have everything you need to become successful in commodity trading.

Remember that commodity prices can be volatile, so always do your research and never risk more money than you can afford to lose. Also,  make sure to use a reputable broker that offers low commissions and good customer service.

FAQ

How Risky Is Commodity Trading?

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All investments carry risk. However, commodities are often considered riskier than other asset classes such as stocks and bonds. This is because commodities are more volatile and can be affected by a number of factors, such as weather and political events.

Is Bitcoin a Commodity?

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Yes, all digital currencies, including Bitcoin, are classed as commodities and regulated by The Commodity Exchange Act (CEA). 

This act was established by the Commodity Futures Trading Commission (CFTC), and it covers all aspects of commodities trading, including digital currencies. Therefore, they are all subject to the same rules and regulations as other commodities, such as gold and oil.

Is Commodity Trading Good for Beginners?

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No, this type of trading is not generally recommended for beginners. That’s because it can be quite risky, and there is a lot of jargon to learn. If you are new to investing, you may be better off starting with something simpler, such as stocks.

How Do I Buy Commodities Online?

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The process is quite simple. You just need to find a broker that offers this service. Once you have found a broker, you will need to open and fund a commodity trading account with them. Once you deposit some funds into that account, you can start trading commodities right away.

About author

Albert Einstein is said to have identified compound interest as mankind’s greatest invention. That story’s probably apocryphal, but it conveys a deep truth about the power of fiscal policy to change the world along with our daily lives. Civilization became possible only when Sumerians of the Bronze Age invented money. Today, economic issues influence every aspect of daily life. My job at Fortunly is an opportunity to analyze government policies and banking practices, sharing the results of my research in articles that can help you make better, smarter decisions for yourself and your family.

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