Commodities Trading

A guide to commodity trading

Commodities are physical raw materials traded on commodities exchanges such as the CME and TOCOM. Trading commodities is usually done using leverage. Leverage tremendously magnifies gains and losses, making commodity trading a high-risk activity. Spot trading refers to physical delivery of a commodity. This is useful for farmers, ranchers and oil refineries, but not for individual traders. Relatively few commodity traders want to be responsible for feeder cattle on their property. Futures contracts enable traders and investors to profit from price movements and provide market liquidity through their trades without ever possessing the actual commodity being traded.

Commodity types

Depending on their origin and use, commodities fit into several categories: agricultural, livestock, precious metals, industrial metals and energy. Diversified commodity indexes mix all types to provide an investment vehicle for “commodities” in general. Agriculture and livestock are sensitive to disease outbreaks, weather extremes and government taxation or support of rural economies. Industrial metals like copper are influenced by industrial demand and discovery of new deposits. Geopolitical unrest relating to mine production, such as a labor strike, can also have a large effect on metals prices. Precious metals such as gold are closely related to currency fluctuations, inflation, jewelry demand and overall economic uncertainty. Energy commodities such as heating oil have similar fundamental concerns as industrial metals.

Placing a commodity trade

When choosing a commodity trading platform, it helps to distinguish between several important players in the commodities market. The most important are commodity brokers, officially called Futures Commission Merchants (FCMs). These actually hold money, deal with margin accounting and execute trades for a client. Traders may not directly interact with an FCM, instead going through professional intermediaries.

A Commodities Trading Advisor (CTA) helps clients make good commodities investment decisions. Investor pools, corporations and individual traders may obtain CTA services. CTAs represent their clients’ wishes to commodity brokers and are licensed to order trades in the name of their clients. Introducing Brokers (IBs) are also intermediaries acting on behalf of a client very similarly to CTAs. A trader is not required to act through CTAs or IBs, though their professional insight into commodity price movements may be worth the price.

Other trading instruments

There are a variety of different derivative instruments that can be used to trade commodities.  Some of the most popular are:

CFDs.  Contracts For Differences are agreements between two parties where one pays the other the difference between the opening price of the underlying commodity and its price when the contract is closed.

Spread betting.  Although spread betting is permitted in a restricted number of countries, it is still one of the most popular methods of commodity trading in countries like the United Kingdom and Australia.
Fundamental and Technical Analysis
Fundamental analysis aims to get a deep understanding of a commodity’s inherent value, or a close approximation thereof. The trader than observes if current market price for that commodity is significantly above or below the determined inherent value. If market value is below inherent value, the trader goes long the commodity, reasoning that in time the market will “correct for its mistake,” to the trader’s favor. Similarly, if commodity market value is higher than inherent value, the commodity price would be expected to fall. In that case, going short on the commodity may be a profitable move.

Each commodity type has some different fundamental factors that influence price movement. Temperature and drought/flood extremes are more likely to affect agricultural commodities. Discovery of large, easily extractable copper or crude oil would affect industrial metal and energy commodities, respectively.

Technical analysis focuses on price movements. Charts, indicators, indexes and averages are the tools of technical analysis. Technical analysis does not care much about the nature of a commodity. Crude oil, corn, silver and any other security, including stocks and currency pairs, are subject to identical technical treatment. The idea is to anticipate future price movements based on past price movements and the indicators accompanying those movements. Technical analysis is based on the premise that all relevant information for a given security is factored into the price. Therefore, all that needs to be analyzed is commodity prices.