What is commodities trading?
Commodities trading is speculating on the price of commodities through derivatives like futures, options, CFDs and financial spread bets.
The recovery in the world economy is continuing apace and this is fuelling a bull market in commodity prices. Here is an overview of commodities and how you can get started trading them.
What are commodities?
Commodities are the building blocks of modern life. Everywhere you go you are surrounded by commodities that are produced and traded around the world. These essential ingredients include food, energy sources and metals.
Some commodities are abundant in nature. Some aren’t. A few commodities are so desired by people they are used as currencies to trade goods for thousands of years, such as gold and silver.
Did you know nearly all modern gadgets – mobile phones and computers – rely heavily on commodities? Look at your mobile phone. It requires copper, lithium, silicon, among others (see below). An electric vehicle requires almost a mile of copper wiring. Wind turbines need rare element elements.
Many investors are realising that the ‘green revolution’ requires tons of commodities – so much so that the phrase ‘commodity supercycle‘ is now back in vogue.
For investors, commodities are an important asset class that should have a place in their portfolios.
The best commodities to trade as a beginner
For beginning traders, commodities appear to be a land of mystery. It should not be. The best way to start is to become an informed observer of the commodity market.
Learning about the commodity market is like learning about the stock market. When starting out, choose the largest and most liquid stocks to watch. Some recent data shows a few of the most traded commodities (by volume) to be:
- Crude Oil
- Natural Gas
Investors like to trade these commodities for a variety of reasons. Crude oil is the lifeblood of modern transportation while gold has industrial applications and is often used as a hedge against inflation.
- Related guide: 50 rules for successful trading
Their ample liquidity means large institutional investors can move millions in and out without disturbing the market.
Commodity sectors returns vary over time
Inside the commodity trading world, each commodity is different. Just like a stock market contains different sectors. Within the commodity universe, there are different sectors too, including:
- Precious metals – gold and silver
- Energies – crude and natural gas
- Food and agriculture – corn and wheat
- Livestock and meat – live cattle and lean hog
- Industrial metals – copper and nickel
The performance of these commodities varies over time significantly. Look at the chart below. It ranked the performance of different commodities over time (2010-2019).
In 2011, for example, gold was the best performer in the commodity world. Next year it was wheat. In 2019 palladium topped the chart. The return gap between the best and worst-performing commodities each year was huge and sometimes over 30-50 percent (see below).
Predicting the return of a single commodity over time is difficult. Most traders focus on trends.
Source: visual capitalist.com
Best commodities trading contracts in 2019
The table below shows the returns or percentage changes among leading commodities and benchmarks year to date. Precious metals are once again the biggest gainers Palladium enjoying a +29.60% gain up until the time of writing. Cotton and natural gas are among the biggest loser year to date in 2019. It has also been a poor year for agricultural commodities and foodstuffs alongside industrial and base metals. It’s also interesting to note the rather pedestrian performance of the general commodity ETF and the CRB commodity index. Two instruments that track the performance of a basket of widely used and consumed commodities.
Source Good Money Guide Research/ Investors Intelligence
Best commodities trading contracts in 2018
The best commodities to have traded in 2018 will have been those that had the biggest return or price moves the table below (part of the periodic table of annual commodity returns compiled by USfunds.com) shows us the major movers in the world of commodities during 2018.
Topping the table is Palladium, a precious metal similar to Platinum, which is used as a catalyst, that gained more than +18.5% in 2018. Wheat gained +17.86% and another grain, Corn, was up by +6.91%. The biggest losers were industrial metals like Nickel, Lead, Copper and Zinc. All of which saw sharp double-digit percentage price falls during 2018.
What drives commodity markets?
Commodity markets are driven by three main factors
- Supply and demand imbalance
- US Dollar
- Business cycle
- Unpredictable shocks
For most commodities, the basic rule is that supply and demand drive prices.
As a rule of thumb, when a commodity is scarce, be it oil or food, prices go up. When the supply is plentiful, prices drop. Of course, like all other financial instruments, prices can overshoot to the upside and on the downside, depending on investor psychology.
The second driver of the commodity market is the movement of the US Dollar. Why? This is because most commodities are priced in the greenback.
When we talked about crude oil prices, most of the time we refer to it in the US dollars per barrel. Ergo, a fall in the dollar means a general rise in commodity prices. You can see this inverse relationship clearly between the US Dollar Index and the S&P GSCI Index below.
Source: sp global
Business cycles can play a huge role in driving commodity prices upwards, especially during the upswing. Since the 1950s, there are a couple of these bull markets that drove commodity prices significantly higher. Many believe we could be on the cusp of another (see below).
The last driver of commodity prices is shocks, be it supply shocks (e.g., mine shutdowns), demand shocks (e.g. new applications), or external shocks (e.g. pandemic).
Take crude oil in 2020. Prices were trading in the forties until April when prices collapsed due to a collapse in demand. Nobody wanted oil at any prices. For the first time in its history, crude oil slumped to negative levels.
For palladium, a demand shock set its prices on fire in 2019 before prices calmed down somewhat (see below).
Source: World Bank Group
Ways to trade commodities
Commodities are widely traded across the world. For new investors, finding out how to invest in commodities alone can be a daunting task. The trick is to gain exposure at a suitable level.
Generally, the most common financial instruments to trade commodities are:
The first question for traders starting in commodities trading is to assess their methods. Are you a long-term investor or a short-term swing trader?
Remember that in trading the first rule is not to lose money. For risk-averse investors starting, buying a single commodity on margin like futures is probably best avoided. Just like a trader starting to invest in stocks, start with a small sum you can afford to lose.
Investing in commodities on a budget
A better choice would be to buy a diversified basket of commodities. This avoids picking which commodity sector will outperform this year. This is like buying the S&P 500 index fund or a Nasdaq exchange-traded fund.
In the US, one of the most popular commodity ETFs is the Invesco DB Commodity Index Tracking Fund (DBC). According to its website, the $1.5 billion ETF ‘‘seeks to track changes, whether positive or negative, in the level of the DBIQ Optimum Yield Diversified Commodity Index Excess Return™ “ and the fund is “designed for investors who want a cost-effective and convenient way to invest in commodity futures.”
Prices of this ETF track 14 commodities. Because of the fund’s weight on energies, prices plummeted in March last year and then rebounded sharply (see below). Volatile stuff.
For investors wanting a single commodity ETF, buying the gold ETF like SPDR Gold ETF (GLD) is often a good choice. The ETF is so big that it is one of the largest owners of physical gold. It has $67 billion assets under management.
Indirect ways to trade commodities
Apart from the above choices, there are two further ways for traders to trade commodities, albeit indirectly.
- Stocks/companies that produce commodities
- Currencies of commodity-producing countries
In the UK, there is a sizeable number of miners, that is, companies that produce raw commodities. These firms are listed on the London Stock Exchange. The two well-known miners are BHP Billiton (BHP) and Rio Tinto (RIO). The latter has been surging to new all-time highs due to the recovery in commodity prices and an ebullient stock market (see below).
Other types of specialised mining stocks in the market include:
- Gold & silver miners
- Copper miners
- Lithium miners
- Uranium and rare earths miners
- Agricultural trading companies
Buying a miner is different to that of a commodity, simply because there is an added risk of the stock market movements and earnings outlook. During a commodity bull market, they often outperform commodities.