How to Start Commodity Trading: A Beginner’s Guide to Commodities in 2021
We interfere with commodities on a daily basis without realizing it. As you sip on your morning coffee, fuel your car with gas, or window-shop golden jewelry before Valentine’s—you are encountering the most evident side of the commodity world. But what’s underneath that widely familiar surface? Profit.
The way how commodities are traded is not rocket science, although it does require a certain level of commitment to get good at. Luckily, you’ve come to just the right place to learn anything there is on how to commodity trade in 2021. Today we will discuss various commodity categories, what drives the commodity market prices, the reasons why commodity trading is one of the best solutions for an online investor, how to successfully trade commodities, and a lot more.
What Are Commodities?
Understanding what commodities are is the very first step to trading commodity market for a substantial profit. A commodity is a raw material or a good that constitutes the massive flow of global trading. Usually, each separate commodity would be a necessary component for a range of products. For example, coffee beans are one of the most recognized commodities. The beans are used by food and beverage companies to make various coffee drinks and by the pharmaceutical companies that extract caffeine to make medicinal substances.
This ability to apply in a scope of ways is one of the main commodity characteristics. Such universality means that commodities produced by different countries are standardized and interchangeable. This also means that there is a unified price across the market, which makes the trading process possible. Although this won’t reflect on the supermarket shelves, the commodity market cost for 1 lb of sugar will be the same in any part of the world.
The physical aspect of commodity trading is what sometimes confuses beginner traders. Does it mean that you will need to rent space to store thousand tons of coffee if you are trading a commodity? Luckily, no. Nowadays, commodity trading is primarily virtual, thanks to the instruments like ETFs and futures, which we will come back to in a bit. First, let’s take a closer look at what specific goods and materials are available for commodity trading.
What Are the Different Categories of the Commodity Market?
There are several ways to categorize the commodities across the market. For instance, we can look at the way they are made, which can be extraction, growing, and producing. Some traders would also separate their commodity trading instruments into hard and soft, which are technically translated into imperishable (oil, gold, gas, etc.) and perishable (orange juice, sugar, live cattle, etc.).
But the most typical way to look at the commodities trade is by the end product’s class. Here, the commodities can be roughly divided into four categories: agriculture, energy, metal, and livestock. Each of these categories has its own set of trading specifics, as well as a certain level of popularity. Just like in any other asset class, some commodities are traded in a larger volume than others due to a variety of factors.
This way, while the Feeder Cattle market had just under 40k contracts in 2019, the Crude Oil volume pushed 14 million contracts. With this particular case, the tremendous contrast is linked to the number of interested participants. Cattle contracts might only involve farmers and stock distribution companies when the Oil market attracts public and government drilling companies, service companies like BP or Exxon Mobil, airlines, and many others. Comprehending this unique nature of each commodity can become an excellent asset during both the instrument selection and actual trading.
The agricultural commodities trade is the most expansive one in the sector, with six distinct subcategories: cereal grains, oilseeds, meat, dairy, other soft commodities, and miscellaneous agricultural commodities. Some of the most popular products in this section are:
- Cotton. The fluff at the end of a Q-tip is just one of a hundred uses for cotton. From clothes to coffee filters and books—the soft white fiber is everywhere, including the commodity market.
- Coffee. Over one-half of the US population consumes coffee on a daily basis. In global terms, this translates into over two billion cups a day across the map. These awakening statistics are one of the driver factors behind active coffee trading. Additionally, as mentioned before, coffee beans are used for medical purposes contributing to another large industry—pharmaceuticals.
- FCOJ. Your morning sip of OJ is part of a large global trade for a commodity known as Frozen Concentrated Orange Juice. Only a century ago, the vitamin-boosted beverage was only available to those who lived in the right climate. Now, thanks to the spread of household refrigerating technologies and the frozen concentrate used for the production of a range of products, we can have the bright juice whenever, wherever.
Natural Gas and Crude Oil are the two most popular commodities to trade, and they both fak under the energy category. The reason for the Natural Gas popularity is sheer demand: the commodity is used for a variety of residential, commercial, and industrial purposes, including electricity generation and machinery operation.
Oil is also used in a large number of enterprises, including the production of fuel, plastic, textiles, cosmetics, and a lot more. But what makes Crude Oil the biggest contributor to how commodities are traded across the globe is the unmatched price volatility. As you probably know, the most significant oil producers are countries like the United States, Russia, Saudi Arabia, and China—all notorious for notable, often radical politics. Such dynamics always reflect on the Oil price, making the trading process both exciting and profitable.
Metals are yet another top players in how commodities are traded. Gold is unarguably the most notable example, as it is both a highly valuable metal and an investor’s safe haven. Traders and investors worldwide turn to Gold whenever the rest of the market is turbulent, which has lately become a new reality.
Although not as widely-acknowledged as Gold, Silver comes with its own set of benefits for international traders. The main reason being the speed at which Silver price tends to move, making it a preferable commodity for fast-paced investing.
Similar to Crude Oil and Natural Gas, Copper is majorly driven by demand. Copper is irreplaceable in electric technology production, plumbing, engineering, and household appliance manufacturing. What’s more, the Copper price is perceived as the ultimate indicator of the Global Economy’s health, making investing in it a solid move for practically any investor.
As we’ve already discussed, livestock commodities get the least action of all groups. However, despite appearing as an odd choice for online investing, subcategories such as Feeder Cattle and Live Cattle consistently deliver profits to everyone involved. The difference between Feeder and Live is the developmental stage of the cattle. Before Feeder grows into Live, it has to pretty much double in weight, which ties the Feeder Cattle trading with Corn trading. There are numerous uses for cow byproducts, aside from beef, including leather and textile production, medicine, hygienic and cosmetic manufacturing, musical instruments, fertilizers, and more.
What Drives Commodity Prices?
At this point, you have a pretty good vision of what the trading commodity scope looks like. Now, let’s spend some time understanding what specifically affects the price of most of the above. It is important to grasp that each commodity will have its own set of influencing factors, which you will need to discover and evaluate before beginning to trade. But it is also true that for the most part, the commodity market, just like any other market for that matter, is largely driven by the supply and demand balance.
Every commodity has a list of its top suppliers. This way, Orange Juice is Brazil’s number-one specialty, just like Crude Oil is Saudi Arabia’s. Familiarizing yourself with the commodity’s origin is crucial for several reasons. For starters, the social and political scene within each particular country can either disrupt to enhance the supply of their forte commodity. This will include events such as shifts in government, wars, protests, strikes, and so on.
Then the commodity producer’s geography will play an equally important role. Location, and more specifically the climate at that location, is always accounted for in any commodities trading how to analysis. Particularly in the case of agricultural and livestock commodities, weather acts as a key factor—if it gets too hot or too cold for a commodity to develop to a market standard, the supply will suffer. In turn, the lack of supply will grow into advanced levels of demand, driving the price up and opening numerous opportunities for global traders.
Demand is affected similarly to the supply in how commodities are traded. Geography and politics will also play tremendous roles, only sometimes in a reverse pattern. For example, a war will reduce the export of the country in crisis and raise the import requirement. Similarly, a country that usually relies on its own corn production will reach out for higher import volumes after a period of unsuitable weather conditions.
Economy health, as well as social tendencies also affect the demand in certain commodity categories. For instance, the environmental trends that dictate switching to artificial leather and plant-based proteins severely affect the agricultural and livestock commodities. This way, when the world gradually became more conscious about sugar consumption, the price of Sugar commodities went down drastically over the last ten years.
The WTI Example
Remember when the Crude Oil price was negative? In the midst of 2020’s pandemic, the West Texas Intermediate (WTI) went to an unprecedented mark of -$37.63 per barrel, which was a rather dramatic drop considering that Oils prices usually average around $50 to $60 per barrel.
The reason behind this one-of-a-kind event was that the Oil producers kept delivering massive amounts of the commodity despite the visibly reduced demand due to a global pause on most transportation methods. To the industry insiders, the monstrous price drop was not illogical—it requires significant levels of human and financial resources to shut down the oil-producing well, and even more to switch it back on. Since the WTI price came back into the usual range, the hiccup on the chart seems almost unreal but still serves as a great example of how commodities are traded in relation to insufficient supply-demand balance.
Substitutions also have a significant place in the commodities trade. When a certain commodity gets either too expensive or lacks supply, the markets will look for a cheaper alternative. For instance, copper is used across a wide application spectrum, but it isn’t entirely irreplaceable. When the price of Copper began to climb up, a large portion of manufacturers switched to aluminum, in turn, driving up its price.
Why Trade in Commodities?
While the most apparent motivation for trading commodity is profit, there are three more reasons why trading commodities in 2021 is a good idea.
- Population growth. In spite of crises and pandemics, the global population continues to escalate at a steady 1% a year, slowly but sure approaching the 8 billion mark. This means increasing demand in nearly all commodity sectors. From infrastructure and transportation to dietary requirements, people will continue to consume. For a trader, this primarily means one thing—an abundance of opportunities.
- Inflation hedging. The value of money gradually reduces with inflation, even in the strongest economies. That’s how a cup of coffee went from costing a quarter to value at nearly $2 in the US over the past decade. However, if you proactively invest in the commodity itself, you will always profit in the long term as the cost of the commodity grows and results in higher paybacks.
- Portfolio diversification. Different asset classes, and within them different assets, progress differently. Consequently, the investors who narrow down a limited scope of instruments are more likely to suffer from visible losses when things go south. While commodities on their own are not a universal diversification tool, adding them to your portfolio will notably broaden your focus and increase the number of potentially beneficial opportunities, at the same time shielding you from many possible risks.
How Did the Commodity Markets Develop?
The concept of how to commodity trade can be tracked down as far as six thousand years back when the ancient Chinese had a record of trading rice. Then the Romans and Greeks began using gold and silver as currency, turning the precious metals into one of the oldest traded commodities.
But the real boost in how commodities are traded today happened just a few centuries ago when the market participants came up with futures trading. A futures contract is an agreement of two parties to finalize a deal on a set date in the future at a price they establish at the time of the consensus. The main reason behind the contracts was the physical aspect of commodity trading.
Let’s say you are looking to purchase some grain crops back in 19th century America. Before the commodity makes it to you, it has to go through a rather long journey of transportation and storage. While the goods are delivered the supply-demand balance might affect its price, not to mention the quality of the end product could be altered due to improper handling, for example. In order to ensure you get your commodity in a decent state and don’t end up overpaying, you draw up a futures contract with the farmer, setting the specifics of the deal ahead, and therefore eliminating many risks.
The modern commodities trade shaped up just about 50 years ago when the physical aspect of commodity investing was no longer crucial to the process with the development of new financial instruments. This expansion put a start to a variety of new jobs, instruments, and profit sources, bringing us the online commodity trading we know today. But how commodities are traded exactly?
How Can I Invest in Commodities?
As long as you are set on the idea of profiting off the commodities trade scene, you have a wide variety of paths to take. From highly inconvenient physical investing to fast and efficient CFDs and ETFs—below, we will take a closer look at each commodity trading approach available for you in 2021.
The most old-school way to commodity trade is to physically purchase the goods to sell them later. For example, head down to Saudi Arabia, buy a barrel of Crude Oil, bring it back home and wait for the price to go up enough to cover your travel expenses. There are two potential issues with this approach. For one, while the average barrel is just about 33 inches high (85 cm), it still weighs approximately 300 lbs (136 kg), making it a bit challenging to stroll around with.
And two—to fully reimburse your transportation and storage expenses, you might have to wait literal decades to break even. With the current rate of events unfolding, waiting is something investors simply can’t afford.
The already mentioned approach to the non-physical commodities trade process is future contracts. Only instead of finalizing the deal by exchanging the contract for a physical good like before, traders speculate on the price changes and resell the contract once the price reaches a satisfactory level. It goes without saying that a price fall would equal a loss in the case of futures trading.
What makes online futures attractive is the ability to use leverage and achieve higher profits when the price goes in a favorable direction. For example, if your futures contract indicates a 1:20 leverage, you will gain access to $20 worth of the commodity for every dollar you invest. However, it is important to keep in mind that leverage magnifies your potential risks proportionally to the potential profits, which means it has to be used with caution.
Commodity options are another form of financial derivative that lets traders benefit from the commodity’s price fluctuations. The main difference from the futures is that an option is not an obligation, but a right to buy or sell a futures contract at a set date. With options, you can profit off both price declines and increases, as there are two available solutions: calls and puts. Call options are sold when the price climbs up, and the put options—vice versa.
This way, if the majority of your ETF’s units show positive dynamics, they overshine the not-so-good statistics of others, and you will profit. Some traders point out, however, that while such diversification does make the critical times less painful, you can seemingly miss out on the individual asset’s strong swings, which could potentially be more fruitful.
Shares are another way of how commodities are traded in modern markets. But through this approach, instead of focusing on the particular commodity, an investor would put their trust in the company which produces the said material or good. For example, trading the Shell stock (RDSA) and not the Oil or Gas commodities.
Now, the thing to keep in mind while investing in commodities through shares is that each company’s specifics add complexity to the analysis and decision-making process. So, while you could essentially benefit more, the whole process will require more effort. For instance, you will have to consider factors like the company’s politics and policies, competition, business costs, interest rates, the geography of production, and more. Depending on how much time you have for trading, you might want to trust your research to your broker's analytical team or reliable third-party info sources.
Finally, CFD trading is the most popular approach to trading commodity assets online. Contracts For Difference (CFD) are agreements between a trader and a broker to exchange the difference between the price of an asset at the beginning of the deal and at the end. For instance, if you opened a CFD to buy Gold when the price was $1,800 and then it went up to $1,855, and you decided to close the position, your profit would make $55. And in the scenario when the price goes down and becomes, for example, $1,775—your trading balance reduces by $25.
There several reasons why trading commodities through CFDs is the most widespread solution, including:
- Convenience. You don’t need to operate with physical assets to open and close CFD positions. What’s more, the market is open 24 hours, 5 days a week, presenting a limitless amount of opportunities.
- Universality. With CFD trading, you can profit both from the price increase and from the price decline. Because the value of the trade is not tied to the value of the asset but rather to the price difference between two points on the chart. Simply speaking, when you do your homework and choose the right strategy—you’ll always benefit.
- No commission. Reliable brokers do not charge commissions on CFDs, which means your trading cost will be visibly lower than when trading futures or ETFs, for example.
As you can see, there are numerous paths to take when it comes to trading commodity assets. And the best news is that there is always a solution for any type of trader, disregarding what's your initial budget or availability. Now, just before we wrap up, let’s quickly go over a few things that you can do to bring your commodities trading how-to to a whole new level.
How Can I Improve My Commodity Trading Results?
The most successful traders are the ones who continue to up their game by constantly discovering and applying new techniques. Just like with any other instrument, your commodity trading can be notably improved through three simple steps.
1. Get Educated
There is no such thing as too much knowledge when it comes to online trading. The market is always evolving and produces thousands of angles and opportunities. So, even after you’ve set your mind on a specific asset class or trading approach, it will never hurt to continue learning about new instruments, tricks, and theories.
Luckily, with the right broker, you will always have free access to tons of free educational materials. Make sure to take full advantage of daily blogs, tutorials, videos, podcasts, and other learning materials, to gradually grow into a trading pro.
2. Analyse the Commodity Market
It is important to find a trading strategy that works for you. But what can be even more crucial when it comes to how commodities are traded is selecting an effective solution to analyze the market. There are two general approaches you can take: technical and fundamental.
Technical analysts look at dry data, compare the chart patterns to the past market events, and apply mathematical principles to come up with an action plan. A huge part of how to commodity trade using technical analysis is identifying the upcoming or ongoing trends to benefit from them using a specific set of instruments.
And the fundamental analysis is a process of exploring all of the external factors that drive the price of a certain commodity. The weather, politics, social trends, and other commodity affecting aspects we’ve discussed above contribute to the fundamental analysis of the market. For instance, knowing that Brazil is experiencing challenging weather for growing oranges, you could assume that in the upcoming month, the FCOJ will be scarce, and therefore its price would go up. This, of course, is just one of the hundreds of ways to analyze commodities, and you will need to find the one that works best for you.
3. Manage Your Risk
Last but not least, risk is an inevitable part of the trading process. And your job is not to avoid it altogether, because without risk, there is no profit, but to find appropriate solutions to keep the potential threats under control and address them on time. Just like with strategy selection and analysis, there are multiple options when it comes to training the trading risks. The best solution is to evaluate your individual outlook on risk-taking and test a few techniques within this range.
How to Commodity Trade in 2021: Final Thoughts
Commodity trading doesn’t immediately seem like a popular choice compared to currencies or stocks. However, the more you get to know the market, the more you will see that it is just as beneficial and exciting to work with. Focus on gathering the right info, and feel free to ask your broker about the options you have when it comes to how to commodity trade, in your particular case.