How to Trade Commodities
- Agricultural – soybeans, wheat, cotton, sugar, etc.
- Livestock – cattle, lean hogs, pork bellies, feeder cattle
Hard commodities are those that need to be mined or extracted such as:
- Energy – crude oil, natural gas, heating oil, gasoline
- Metals – gold, silver, copper, platinum
As society progresses, new commodities are added to the trading centres. Commodities now include plastics, iron and steel, machinery, and vehicles. They may include things like wind, solar, biofuel, or even carbon emissions or offsets and renewable energy certificates.
Commodities have symbols similar to stocks. West Texas Intermediate crude oil goes by WTI and is a benchmark for other oil standards. Wheat traded on the Euronext Exchange goes by EBL and live cattle go by LE. Contract sizes tend to be huge. Live cattle trade in 20 tonne lots, wheat in 50 tonne lots and West Texas Crude in 42,000 US gallon lots.98
Because lot sizes are so large, commodity trading has traditionally been the province of hedge funds and large institutional traders. Even trading with leverage and margins requires a sizeable investment and risk. Trading with CFDs lets people trade fractions of lots and makes the trading available to the average investor.
Commodity trading takes place in exchanges around the world. Different exchanges specialise in different commodities. Often they trade in the commodity produced by their country or those nearby. Some of the largest exchanges are:
- Chicago Mercantile Exchange – USA
- Tokyo Commodity Exchange – Japan
- Euronext – Europe
- Dalian Commodity Exchange – China
- Multi Commodity Exchange – India
- Intercontinental Exchange – Multinational
- African Mercantile Exchange – Kenya
- Uzbek Commodity Exchange – Uzbekistan99
The market that drives commodities is different from that which propels stock exchanges. They respond to different stimuli than stocks or currency, and so offer another avenue to trade. Weather, natural disasters, politics, and supply and demand all influence commodity prices. In areas of political unrest, the market prices can fluctuate more dramatically.
For example, when there is tension in the middle-east, oil prices react. A drought in the mid-west section of the USA will affect wheat prices. Or alfalfa scarcity will drive up cattle prices. While some of these issues may also affect stock or currency prices, many of them will have a much more volatile effect on commodities. This gives traders the chance to profit in commodities when the volatility may be low in other assets.
15.1 Commodity Trading History
The Sumerians may have been the earliest people to use commodity-based money or trading. As early as 4500 BC they inscribed clay pots with the commodity – grain or goats – to be delivered. Thus, the beginning of futures contracts.100
People continued to trade gold and silver, pigs and sea shells. In the 1400s reliable scales allowed farmers to weigh their commodities for better standardisation. And in 1530 the Amsterdam Stock Exchange began using complex contracts like options, forward contracts, and short sales.101 The Chicago Board of Trade (CBOT), started in 1864, was the first to truly quantify and standardise commodities.
The CBOT started by trading agricultural products: wheat, corn, cattle, and pigs with the kind of futures contracts and options still in use today. By 1940 the CBOT had expanded to include a multitude of soft commodities. In 1952 the Bureau of Labor Statistics started publishing a Spot Price Market Index that followed 22 commodities. Traders started using it as an early indicator of possible changes in the economy of the country.
It wasn’t until the 1990s that commodity index funds were created. After all, it’s hard to hold the perishable underlying assets. Instead, the funds invested in financial instruments that were linked to commodities in the index. The exceptions to this were some gold and silver funds that actually held the physical gold or silver in vaults.
The 1990s also saw expansive growth of emerging economies in Brazil, Russia, India, and China. Commodity exchanges expanded throughout the world to feed the increased demand from these countries. This commodity boom lasted until 2012.
By 2011 electronic trading had taken over the buying and selling traditionally handled by floor traders. This allowed high-frequency trading and algorithmic trading that favour commodity speculators. As speculators entered the market, some feared they were ramping up the price of the commodities.
People claimed rich banks and traders were making money by starving people with high food prices. An article in Forbes indicates this has little merit.102 Over the last 50 years as the population has increased from 3 billion to 7.2 billion, the cost of food, as shown by the World Food Index, has gone down. This decrease has come even as the number of traders and speculators has increased.
There were also complaints that the commodity traders increase price volatility and make it more expensive for companies to hedge their costs by fixing the price of the commodities they need. But others said that companies and farmers need the speculators as counterparties for the other side of their trade. In 2014 the US Commodities Futures Trading Commission (CFTC) set limits on 28 commodities. They restricted the amount of supply speculators could use to trade. 103
Traders of commodities can feel confident their trades are not affecting market price. Plus, when you trade CFDs you are free from any of these limits because you are not trading the commodities, only trading on the price changes that occur.
15.2 Commodity Terminology
Before you start trading commodities, it’s useful to understand the specific language traders use. Here is a brief glossary to get you started:
Cash Commodity: holding the actual asset of gold, silver, oil, cattle, etc.
CBOT: Chicago Board of Trade. One of the world’s oldest futures and options exchanges.
Derivatives: These are contracts such as futures, options, or forwards based on the physical asset. They can be redeemed by the asset or, more often, sold before the commodity transfer takes place.
Forward Contracts: An agreement between two parties to purchase a commodity at a specific price on a specific date. This is a form of hedging and the settlement takes place on the closing date.
Futures Contract: These exchange-traded contracts are standardised and the payment is made at the beginning of the period and ‘settled’ or rolled over each day until the end of the contract. Speculators use these contracts to try to make money on the changing price of the commodity and typically close them out before maturity.
Margins: A certain level of funds needed in your account when you use leverage to make a commodity trade.
Margin Call: The requirement to deposit more funds into your account to cover a commodity trade that has lost money. This is done to bring your account up to the appropriate margin needed for trading. If funds are not promptly deposited, the broker will liquidate a position to cover the margin call.
Options: Options give you choices. You can buy or sell the right or the obligation to buy or sell a commodity within a specific time. The end of the time is called the expiration date. Buying a put or call, gives you the opportunity, but not the obligation, to collect the commodity if the price rises (call) or falls (put) into the price you set for the option. Selling a put or call brings you up-front money. But it requires you to deliver the asset if the price comes in the money or beyond your agreed upon price at or before the expiration date. This exposes you to unlimited risk if the commodity spikes (with a call) or drops like a stone (with a put.)
OTC: Over the Counter trades. These are made by two parties without going through the exchange. It is more private and less secure.
Short Sales: This is selling a commodity you don’t own. Traders who make short sales assume prices will drop during the term of the contract and they can repurchase the commodity at a lower price. If they are right, they profit from the price difference. If the commodity rises, they must pay the difference between the sell and buy prices.
Spot Contract: Commodity delivery takes place immediately or within a day or two of the contract start date.
Standardisation: Specific tests and standards, so traders know the quality of the commodity they are buying. All coffee beans of a certain size, colour, and species may be one standard. They are identical even if they come from Panama or Kenya.
Swaps: The consumer gets the commodity at a guaranteed price and pays in advance for the commodity. The producer is hedged from a price decline but gets a slightly lower price for the commodity. Since he pockets the money up front, the sales price is reduced by the interest earned on the money over the swap period. At the end of the period, the swap can be settled with a cash difference or with the commodity. Swaps are a common hedge.
15.3 Nine Ways to Trade (or Own) Commodities
As has been explained above, there are many ways to try to profit from commodities. Here are some specific buying, selling, and trading strategies. Consider your risk tolerance as you review them.
- Own the Asset. If you live on acreage, you might buy cattle or goats. If you desire gold, buy the physical asset. If you heat with fuel, buy larger tanks and store more. When you own the asset, you take advantage of upward prices, but fall victim to price drops. Still, the asset of gold or silver carries intrinsic value and beauty, and many people own it as a hedge against devaluing currency.
Owning the asset limits your losses to the amount you invested.
- Commodity Exchanges. By far, the majority of trades take place on exchanges. Here the products are of a standard quantity and quality. Commodity exchanges are all over the world, with some trading in a few specific commodities and some covering almost all of them. Most individual traders, hedge funds, and companies who speculate, trade on the exchanges. These exchanges guarantee the trades will be executed and honoured. However, they still carry considerable financial risk.
- Trade Commodities OTC. Usually companies, farmers, and those who have or need the resource use OTC (over the counter) contracts to buy or sell commodities. These commodities may be personally inspected to see the quality as they are not guaranteed to be a specific level or standard by a governing body. Some commodities are not sold on exchanges, such as rare metals, common minerals, pressed oils, or vegetables. They are only available OTC. OTC contracts can take the many forms shown under futures contracts. These contracts may expose you to more risk than your initial investment and carry the additional risk of default, where the other party does not fulfil their part of the agreement.
- Futures Contracts. The most common method of trading is with futures contracts. The futures contract specifies the:
- Exchange traded on
- Delivery location
- Delivery date104
The seller agrees to deliver the commodity on the delivery date. Speculators sell the contract before the delivery date. The amount of a commodity in any one contract is substantial. It will be thousands of bushels or barrels, or tonnes of goods. Traders use leverage to take advantage of price movement without needing to have the entire cost of the trade in hand.
You can buy (go long) or sell (go short) a futures contract depending on the direction you think the market will go. Long anticipates the price will rise and you keep the profit when you sell. Short anticipates the price will drop and you can buy it back at a lower price. As the trade progresses and your exit points are reached, most traders exit the trade. They do not want to own the commodity, only to trade on the price volatility.
Be aware that futures contracts are settled each night, and a new contract price is in effect for the next trading day. If the price has dropped, the margin amount changes and the traders must immediately ensure they have enough money in their account to cover it. These overnight or carry fees are shown on your trading platform. Traders are ultimately responsible for the entire amount, even when they have borrowed money from the broker for the trade. This creates very high risk. The longer you hold the trade, the more carry fees you will incur.
- Options. As mentioned above, options give you a chance to buy or sell puts and calls. Most options expire worthless or ‘out of the money’. This means that traders who sell puts or calls usually just collect the money and don’t have to pay out. But the risk can be substantial if the price of the commodity changes rapidly. The advantage of buying options is that you limit your downside. The most you will ever lose is the amount you paid for the option. And if the commodity comes ‘into the money’ or even closer to the agreed upon price before the expiration date, you can make a nice profit. Some traders use a mix of puts and calls, both buying and selling at different prices or expiration dates to minimise risks and enhance profit potential.
- Binary Options. Binary options, or digital options, are derivatives that trade on the underlying asset. You don’t own the asset, rather, you buy an option based on the direction you think the commodity will trade. You can use small amounts of capital and no leverage. You have a fixed price and fixed payout or loss on a yes/no question. Binary options can expire in an hour, a day, or a week. Most binary options brokers are scams and regulators are currently cracking down on them.
Notice that the binary options trade does not follow the price of the commodity; rather it varies between zero and 100%. When the option expires, the trade closes. Either you are right, or you are wrong, two choices. That’s why it’s called binary options. For example: Will gold rise above $1200 by 6pm tonight? You think yes, and open the trade at the going rate – say $50. At 6pm, gold trades for $1213. You are paid the rate fixed for this trade, say $100 and earn a $50 profit. If it closes at $1195, you lost your $50 and earned nothing. It does not matter if gold climbs to $1300, your max profit is the agreed upon payout. And your max loss is the cost of the trade.
- ETF. Stock market investors gain access to the commodities markets through exchange traded funds(ETFs). This is an easy way for the average investor to gain exposure to this asset class. Some of these funds actually hold the commodity, usually gold or silver funds. Holding physical gold or silver carries risks of security and also tax consequences with buying or selling. Most ETFs just hold derivative papers such as futures contracts or options. These instruments do not align exactly with the commodity prices. So if the commodity goes up a certain amount, the ETF is unlikely to rise the same amount or at the same time.
- Stocks. Stock market investors who want exposure to commodities may also buy companies that have a holding in the commodity such as oil and gas companies, junior mining stocks, or precious metal streaming companies. They can invest in aluminium through Alcoa, or steel through ArcelorMittal or other similar companies.
- CFDs. Contract for Difference (CFD) offer an alternative entry to commodity trading. You trade on the underlying asset, so your prices correlate exactly with the price changes. You can trade fractions of a lot, so you don’t need as much money to enter the trade or as much margin to stay in the trade. You can still use leverage to increase your profit potential and your risk. It’s also easy to move between stocks, indices, currencies, and commodities because they are all traded on the same platform.
Remember all trading carries risks. Use of leverage increases your risk factors. You have the chance to profit or lose money in your trades.
15.4 Commonly Traded Commodities
Many speculators focus on trading in precious metals and oil and gas. These commodities have intrinsic value, are highly volatile, and trade frequently. The easiest way for individual day traders to take advantage of commodities is through CFDs. Let’s take a look at why you might want to trade in these commodities.
Copper: Copper is the third most widely used metal in the world and is in demand, especially as economies grow. High conductivity and malleability make it useful in electronics, motors, wires, and cables. It’s also used in solar panels, telecommunications equipment, and car batteries. It does not corrode and is an essential part of alloys such as bronze and brass. It also is one of the most affordable metals.
Copper prices moves in tandem with the state of the economy, especially the construction industry. Copper can signal an uptick in the health of a nation as sales of homes, electrical appliances, and other copper using technology increases. Spot prices can also be influenced by mine strikes, political instability in mining regions, and increased demand as people turn to solar power. Supply and demand affect price and current mines have a limited number of productive years remaining.
Prices can move dramatically even within an hour, so traders must pay close attention to their trades or pre-set exit points. As always, trading commodities involves a high level of risk. Copper trades in 25,000 pound lots under the ticker symbol HG.
Gold: Gold has long been valued as money and as a safe haven in times of unrest. It is also used in computers and jewellery. Most of the gold comes from China, South Africa, the United States, Australia, Canada, Indonesia, and Russia.
Gold moves with supply and demand. Demand increases in times of insecurity or increased prosperity as more people buy gold. World and national politics, political turmoil, monetary policies, and the US dollar affect gold prices. Since gold is typically quoted in US dollars, strength or weakness in the dollar usually, but not always, affects the price. Gold prices decrease when investors are confident other assets offer better returns.
Gold is sold in 100 troy ounces lots with the ticker symbol of GC.
Natural Gas: Natural gas is a highly volatile commodity that is cyclical in nature. It is used primarily for heating and cooling as well as running energy plants. Price moves with supply and demand, which are often controlled by nature. A cold winter increases demand. Increase or decrease in oil output also influences supply.
Traders keep an eye on stockpiles and the weather forecasts as they trade. Natural gas prices are most volatile in the high demand seasons of December to February and in July and August. At other times of the year, natural gas prices may see a lull.
Natural gas trades in 10,000 million BTU lots and has a ticker symbol of NG.
Oil: Crude oil is the basis of petrol, liquefied petroleum gas (LPG), naphtha, kerosene, and diesel and jet fuel. Oil is also the basis for most plastics. Oil with less sulphur is called sweet. Oil with low density is called light. Light, sweet crude takes less time to refine and so is more desired.
Crude oil is traded more frequently than any other commodity in the world. Volatility in oil prices comes from the news: political unrest, possible disruption of oil fields, and changes in supply or demand can all impact the price. Russia, the Middle East, and the United States produce the most oil, so changes in their politics or production make the most impact.
Nature also plays a role in crude oil’s volatility. Heating fuel comes from oil, so a cold winter will increase prices. A temperate summer can encourage a busy summer driving season which may increase gas demand. Emotion also drives the oil market. Fears and worries, even unrealised, can rocket oil futures.
1,000 US barrels or 42,000 gallons make a futures trading lot. Oil trades under a variety of tickers depending on the type and quality of the oil.
Palladium: Palladium is similar to platinum, but even rarer. It’s resistant to heat, chemicals, and tarnish. It is softer, so it can be more easily shaped. An inert metal, palladium can absorb 900 times its own volume in hydrogen. Palladium is used in jewellery, dental work, electronics, fuel cell production, and, most often, in catalytic converters for cars.
Traders like palladium because it is 30 times rarer than gold. The demand for palladium is increasing, but the price is still relatively low compared to gold. Some use it as a hedge against inflation.
Russia and South Africa produce about 80% of the world’s palladium. Because Russia controls nearly 50% of the market and is secret about its stockpiles, uncertainty makes the asset volatile. Political tensions in the regions and auto production impact price. Typically the price of palladium goes up as car production increases.
Palladium contracts sell in 100 troy ounce lots with a ticker symbol of PA
Platinum: Platinum has a high melting temperature and is corrosion resistant to air. It has high electrical conductivity and yet is non-reactive to chemicals. It is more useful than gold as it is a part of products as diverse as catalytic converters, dental equipment, jewellery, and thermometers. It is also about 15 to 20 times scarcer than gold which typically gives it a higher price than gold.
Russia and South Africa produce a majority of the world’s platinum, so strikes or political unrest in either area can shock the price. As always, supply and demand play a part. Nearly half of the platinum goes into cars. If a cheaper option for catalytic converters is found or if too many cars shift to electric, demand may drop.
Contracts trade in 50 troy ounce lots with a ticker symbol of PL.
Silver: Silver is easy to shape and very conductive. It has a long tradition of use in jewellery and money. Indeed the British pound originally equalled one pound of sterling silver. It also serves industrial purposes and can be found in electronics, household appliances, photographic equipment, x-rays, and even anti-bacterial odour control in shoes.
Silver has traditionally stood as a hedge against inflation, deflation or devaluation. It is highly volatile and has traded as high as $110 in 1980 to a low of under $6 in 2001. The peak came as a group of investors tried to corner the market on silver.105 The price spiked, then tanked.
The low cost and high volatility of silver make it attractive to trade. Its price changes seem correlated to other precious metals. People buying physical silver as a hedge against currency concerns may affect the price.
A silver contract is 5000 troy ounces and trades under the symbol of SI.
Gold, silver, oil, and natural gas are the most frequently traded commodities. If you decide to enter commodity trading, keep tuned to the news that affects the industries that use your commodity. Pay close attention to countries that hold large reserves and the political events surrounding them. Recognise that supply delays and shipping problems caused by weather or disasters are likely to impact price.
Know that commodity trading is high-risk trading. Your capital may be at risk. Leveraged trading increases your risk. While you may only use a small amount of your money to control a large contract of assets, you are responsible for the entire amount. Trade wisely.
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