How to Start Commodity Trading: A Beginner’s Guide to Commodities in 2022

With the development of technology and the Internet, investing can take many different forms. There are dozens of financial instruments available to anyone wishing to invest funds to multiply it. One of them is investing in the commodities market. And there is no need to go somewhere for this purpose, to prepare warehouses for storing purchased goods and take care of their logistics. Then what is the point of such a market? It's quite simple: to set a fair price for goods and raw materials, control risks, and make a fortune.

The commodity market functions through exchanges. People have been selling, buying, and exchanging commodities for thousands of years. That is why operations with raw materials and commodities are much older than operations with currency or securities. In the early days of commodity exchanges, transactions were almost always accompanied by the actual sale of assets. But that is a thing of the past. Of course, at some exchanges, it is really possible to buy or sell real goods, but such deals are very few. Trading is mostly done with or derivatives. Let's talk about that in more detail.

What Are Commodities?

Commodity markets are markets in which there is a trade-in certain types of goods or raw materials, which are formed into separate commodity groups, such groups include non-ferrous metals (copper, tin, lead, zinc, aluminum, nickel), precious metals (gold, silver, platinum), energy carriers (oil, gas, fuel oil, coal), forest products and a whole group of agricultural products of plant and animal origin (meat, dairy products, wheat, sugar, coffee, cocoa, rice, corn, soy).

An important feature of exchange-traded commodities is the pricing mechanism. Conditions close to ideal competition are formed at the exchange. The price for such commodities depends on global supply and demand.

It is important to understand that on a commodity exchange, it is not a commodity that is traded, but a futures contract. Each futures contract on a commodities exchange is simultaneously a purchase for one party and a sale for the other party. The selling party takes a short position as it sells, and the buying party takes a long position as it buys.

For an example of how trading happens, imagine that you are buying a one-year subscription to a magazine today. Such a magazine subscription is very similar in nature to a futures contract: both futures and subscriptions guarantee you a certain price for a commodity in the future. Think about it: if the market price of the same subscription increases a month after the subscription, the editorial office has no right to demand more capital from you because the price has already been determined, and changing the terms would be a breach of contract. Thus, you will have a commodity (a magazine subscription) whose market value is higher than yours.

However, it is worth noting that commodity markets are traded mostly by speculators. Really, why do traders need a barrel of oil or a ton of raw iron? The real deliveries are only 1-2% of the time.

As a consequence, the market of commodity assets is highly volatile and not suitable for investors and novice traders. The only exception may be precious metals, but their physical receipt and storage is also quite a complicated procedure.

What Are the Different Categories of the Commodity Market?

Commodities are an important structural element of the market economy. The efficiency of commodities markets determines the optimal use of resources and, therefore, the stability and balance of the economy, and the effectiveness of firms and enterprises. On our planet resources are distributed unevenly, and all countries are interested in the exchange, if in one country a good can be produced, the production of which in another country is impossible, and vice versa.

Commodity markets are highly dependent on natural and geographic factors. The investment in the assets of raw materials and the speculation on such markets demand a great deal of preliminary preparation and training from the participants. It is not recommended for beginners to trade on the commodities exchanges. There are about one hundred basic exchange commodities, which makes one-fifth of the whole international trade, in the world commodity exchanges.

Unlike the currency market, which has no specific location, transactions in the commodity markets are carried out on special commodity exchanges.

xDirect provides access to the largest world exchanges, such as CBOT (CME Group) - Chicago Mercantile Exchange, NYMEX (CME Group) - New York Mercantile Exchange, ICE (Intercontinental Exchange) - Intercontinental Exchange, LME - London Metal Exchange, and others.

You can trade more than 20 commodity products, which can be roughly divided into the following categories: energy, metals, and agriculture.

Agricultural Commodities

This category includes assets such as cotton, coffee, corn, soybeans, and sugar. Weather conditions have a strong influence on quotations here. If you are interested in investing in such assets, keep in mind that population growth and a weak supply of products due to adverse weather can actively push prices up, which will give you the opportunity to capitalize on such investments.

Energy Commodities

Energy commodities include WTI and Brent crude oil, natural gas, fuel oil, gasoline, and so on. It is worth noting that Brent oil has been showing strong growth since late April 2020. At that time prices were falling to the level of $16 a barrel, and today quotations reached $70 a barrel.

The economic stimulation during the coronavirus pandemic provoked a rise in oil prices around the world. Even now the major banks began to talk about the resumption of the long-term cycle of growth of oil prices with the goal of climbing above $120 per barrel.

Metal Commodities

This group includes gold, silver, platinum, copper, and other precious and mined metals. In times of crisis and economic turmoil, investors often invest in gold because of its status as a protective asset.

Indeed, the precious metal has been on the rise since mid-2018, and in 2020 it renewed another all-time high. Now the global economy is recovering, and gold prices have slumped somewhat, the danger of the crisis has passed, but traders expect another attempt to climb to the tops shortly.

What Drives Commodity Prices?

First of all, we must remember how markets work nowadays. In the past, most markets did not communicate with each other. At the very least, there was a lag in information, especially in large markets. This meant that prices would move in each market according to local supply and demand. Merchants could buy in one market and move to another in hopes of getting a return there since the prices of the desired goods were different. As time went on, markets all over the world were getting connected. Eventually, we ended up in the situation we are in today. Almost all markets have the same or very similar prices for all goods. Thanks to the miracle of the Internet, one market can easily inform others about assets. In addition, the movement of goods is easier than ever.

In the past, traders moved their assets themselves over long distances, on foot, and by boat. This took a very long time and with it was a very risky enterprise. Thus, the people who paid for their goods in other markets also paid transportation costs. Now, however, transporting goods has become much easier. The process has become much faster, and no one is putting their life in danger. Moreover, there is basically a guarantee that the goods will reach their destination. So the prices tend to be more stable. This is also one of the reasons why futures contracts are so common today. People know they are getting what they paid for.

Commodity Supply

However, this is not the full picture. Equally important is supply. If there is plenty of supply, prices will be lower. This is because suppliers have more leverage over their products, so they can demand higher prices. This is why prices for commodities such as crude oil are not as high as one might assume. Currently, oil is in abundance, so prices are correspondingly low.

Commodity Demand

Some countries price the goods they don't have or want the most. Prices for those goods that people want the most will go up. It's pretty simple. The less they value a commodity, the more its prices go down. This demand comes from companies that need these raw materials for their services. It usually comes from using it in other commodities. If they realize that they have found another commodity that performs this function more effectively, its price will rise with the demand. The ultimate source of capital is society. They determine companies' strategies and determine where the earnings come from. So, in the end, it all comes down to the needs and desires of the public. For example, during the coronavirus crisis, oil demand became much, much lower as people stayed home. This had the side effect of falling oil prices, in some places even negative.

Commodity Demand - oil example

Oil becomes more expensive when there is a threat of supply shortage and cheaper when there is a surplus. anything that changes the balance of the market - changes in production or reserves, pipeline accidents, wars, trade restrictions, etc. - can affect the price.

Oil does tend to get more expensive when there is a threat of supply reduction, and cheaper when there is an expectation of a surplus. And so the price will react to anything that might change the balance in the market: a reduction or increase in production or reserves, pipeline accidents, tanker force majeure, wars, trade restrictions, and the like.

Textbook examples of price dependence on supply and demand factors are associated with political dramas in the oil-rich Middle East and the Persian Gulf. The Arab embargo on oil supplies to the US and the countries that supported Israel in the Yom Kippur war pushed world oil prices from $4 to $10 in 1973. The Iranian revolution in 1979 and the Iran-Iraq war pushed prices from $16 in 1979 to $34 in 1980.

In 7 years, rising production in Saudi Arabia, the North Sea, and the Gulf of Mexico with reduced consumption led to a threefold drop in prices to $10 per barrel. The surplus kept prices down until the early 2000s, when oil consumption grew sharply at the expense of the growing economies of Southeast Asia, especially China and India. Thus, the 1980s and 1990s have remained in history as a period of low prices (on average $15-20 per barrel in current prices).

Commodity Substitution

The substitution effect is an effect in microeconomics when in the set of two goods consumed by an economic subject, one of the goods becomes cheaper, and this is accompanied by an over-proportional increase in demand for this product.

Due to the limited budget of the economic subject, this means that the cheaper product replaces a certain amount of consumption of the product unchanged in price. If a fall in the price of one of the products leads to an increase in the consumption of both products, we are talking about the income effect.

How Weather Affects Commodity Prices

For example (as it was several thousand years ago), the baker agrees with the wheat farmer for wheat. They agree in the spring to deliver wheat in the fall. Both parties - the seller and the buyer - believe that 10 U.S. dollars would be a fair price for a bushel of wheat in the fall, and they are both happy with that price. They agree to deliver 1,000 bushels of wheat at 10 dollars in October.

Suppose that by the fall drought has killed some of the crop, and the total volume of wheat on the market has decreased, and the price of wheat has risen accordingly to 15 dollars per bushel. In this case, in the fall, when our baker and wheat farmer are ready to close the futures contract, the baker is happy about the earnings, because he bought 1000 bushels at 10 instead of 15 like everyone else. In turn, the farmer is not happy, because he could have sold his wheat in the market at 15 per bushel, but is forced to sell it according to the futures contract at 10 dollars per bushel.

In this example, the wheat grower and the baker are members of a commodity exchange. When the futures are due, the wheat maker's account is credited with 5,000 dollars (i.e., 5,000 is taken from him), and the baker's account is debited with 5,000 (he is credited with 5,000 because he earned 5 dollars on each bushel).

Why Should I Trade in Commodities?

If you are worried about inflation and other economic disasters, commodities can be a safe haven for you to invest in. Although they are as volatile as stocks in the short term, over the long term gold holds its value remarkably well.

Liquidity

Transactions with commodities are easier than other physical assets, such as real estate.

It can take months to buy or sell physical real estate. When trading a commodity, everything happens instantly, and there are always buyers and sellers.

Inflation Hedging

When inflation rises, cash depreciates - with the same amount of funds, fewer and fewer goods can be bought over time. At the same time, the value of tangible assets such as gold increases. In the long run, almost all major currencies have depreciated relative to gold.

Gold is a lifeline during periods of hyperinflation, when currency is depreciating at a galloping rate, as in Germany in the 1920s or Venezuela in recent years, with inflation at about 4000%.

Portfolio Diversification

The essence of diversification is to find instruments that are weakly correlated with each other - that is, that behave differently under the same conditions.

Metals are an excellent diversifier, as they are historically negatively correlated with stocks: when stocks are cheaper, gold is more expensive.

But it is worth noting that sometimes they move in the same direction - as was the case in the 2008 crisis when gold dropped along with stocks.

How Did the Commodity Markets Develop?

In Europe, commodity exchanges appeared in the Middle Ages, much earlier than stock exchanges. In the middle of the XV century, an organized commodity exchange opened in Antwerp, which existed for more than 100 years. Initially, trade transactions were carried out on the special square, but after the exchange building was constructed in 1531, it was moved under the roof. In the USA exchanges started developing actively in the middle of the 19th century when capitalistic relations were established in the economy.

In Russia, the first commodity exchange appeared in St. Petersburg during the reign of Peter I, who adopted the experience of the Netherlands. A few decades later, the second one was opened in Arkhangelsk. The Moscow Stock Exchange became the sixth one and gained full-fledged status only in 1837. In CIS countries, the list of exchange commodity objects includes not quite usual for the world community cars and real estate.

The term commodity, or commoditize, which means "commodity" in English, is used to denote the specificity of the exchange commodity. The similar French term commodité has a slightly different content: comfort, convenience. In both words, there is the Latin root commod-, denoting advantage, benefit, proper quality.

How Can I Invest in Commodities?

Now that we've figured out what commodities are, let's move on to ways to trade these instruments. There are several popular options for investing in commodities.

Physical purchase

One of the options is the direct purchase of raw materials. After buying, the investor will have to wait for the price to increase, then find a buyer and sell him this raw material to benefit from a deal. However, this method involves the material and time costs of buying, transporting, storing, and searching for a new buyer.

Experienced investors point out that this option is only suitable for commodities with high added value, such as gold and silver. Indeed, such a purchase allows you to gain access to physical gold or other precious metals, and later to feel the real result of such an investment. However, high costs, as well as investments only in base metals, make such an option not too attractive.

Futures on commodities

One of the most popular ways to trade commodities is buying and selling futures contracts on the exchange market. The essence of futures is that the buyer agrees to buy the commodity at a certain price in the future. However, the contract is not really delivered; by the end of it, the contract must be closed.

If the trader expects the growth of the commodity price in the future it is enough to buy a futures contract: in case of real price growth, the trader will benefit. The disadvantage of this approach is a commission for the transaction. The absence of all expenses accompanying the purchase of a physical asset is a great advantage.

CFD on commodities

The contract for difference (CFD) is a financial instrument, which allows trading any of the offered commodities without actually buying them, thus earning only on the price difference.

Some types of brokerage accounts allow the trader to trade CFDs without commissions for opening and closing the position and "pay" only the spread, i.e. the difference between the buying and selling price of the commodity.

Shares

Another option for trading commodities is to purchase shares of companies that are directly related to a particular commodity. For example, instead of investing directly in oil, you can buy shares of a refining company.

However, here too, the value of the stock will directly depend on the value of the underlying commodity. If oil prices go up, refinery stocks will go up as well. Traders point out that investing in stocks of commodity companies is less risky than investing directly in commodities. Some companies can continue to get earnings even as commodity prices fall.

Commodity ETFs

Commodity ETFs are a ready-made set of commodity stocks. Such funds pool funds from small investors to create one large portfolio. The fund may also buy futures contracts or stocks of various companies in the commodities sector. There is a perception that commodity ETFs are cheap and readily available and have high liquidity. Here, an investor with tiny capital has access to a wide range of commodities.

How Can I Improve My Commodity Trading Results?

No doubt, trading commodity market is not something easy so here are some tips to improve your results:

1. Get Educated

As we know, the world is not standing still and everything is changing all the time, so the best you can do is to never stop learning. Keep reading specific trading commodity articles, follow different analysts and opinions to be on top of things.

2. Analyze the Commodity Market

Now you need to analyze all the obtained information and decide if it's worth investing in the underlying asset or not. Trading is not about following someone's lead, it's about analysis and making a decision.

3. Manage Your Risk

Risk management is the part of the trading system that specifies how many specific lots you can buy and the maximum risk you can hold in a position. Money management affects assets, trading volumes (as the size of one trade, the total amount of all trades), your total capital, individual and aggregate risk tolerance.

In simple terms, a risk management strategy determines your allowable loss and return, which is why it's critical, especially for a wealthy trader.

4. Diversify Your Portfolio with Commodities

Diversification will help reduce losses when certain securities fall and benefit from different instruments. Why this is important is again well illustrated by the current crisis. When stocks go down, the price of gold skyrockets and vice versa. This will create a balance in your portfolio and allow you to lose as little or no return as possible.

Choosing a Broker

The success of the trading commodity market directly depends on the choice of broker. How to make a choice? Preference should be given to reliable intermediaries with a good reputation. Before stopping your choice on a particular broker, it is recommended to collect information about it: how long it exists in the market, what spread and leverage conditions it offers, what kind of reviews it has. It is best to choose a broker that has been on the market for several years and has already earned a good reputation.

About AdroFx

Adrofx is an online CFD broker that offers tailored trading features, competitive conditions, and a robust WebTrader platform, Allpips. The AdroFx brand is aiming to deliver excellence which is evident in the services they provide.