Commodity trading dates back to ancient times. There was already a commodity exchange in Sumer (today’s Iraq) between 4500 and 4000 BC. Local traders used clay tokens as exchange currency to trade goats. In 17th-century Japan, rice traders used so-called “rice tickets” to sell their inventory to willing buyers.
Commodity trading only gained global importance in 1848, however, when the Chicago Board of Trade was opened. Today, commodities are among the most popular financial instruments in the world. They are popular with commercial traders, institutions, and speculators alike.
What are commodities?
The raw material is a naturally occurring material used in trade and industry. Individual commodities are typically building blocks for more complex goods and services. For example, the raw materials sugar and cocoa are components of a chocolate bar.
Raw materials differ from other goods because they are interchangeable and standardized. This means that no matter where or by whom a raw material was produced, two equal units of raw material have the same quality and price. So what are the different types of commodities used in commodities trading?
Generally speaking, commodities are either extracted, cultivated, or produced. Your breakfast is likely to contain several raw materials. The primary raw materials include sugar, cocoa, and coffee beans. A variety of other commodities can be traded on the commodities exchanges, so let’s look at the four major commodity categories in the next section.
Commodity trading: The 4 categories in the commodity market
In commodity trading, four main categories define the commodity market and within which commodities can be traded:
- Agricultural commodities: sugar, cotton, coffee beans, and more
- Commodities from the energy sector: oil and gas
- Metal commodities: Precious metals such as gold, silver, and platinum, but also base metals such as copper
- Livestock: Cattle, pigs, poultry, and other meat products
Here you can see just a small selection of the different commodities from the four categories of the commodity market. Before we look at how to learn how to trade commodities, it’s essential to understand that most traders and investors stick to the most traded commodities — or the most liquid in the financial markets.
Some commodities are traded more actively than others. The forage livestock market consists of the rancher and the distributor, with not much trading activity. According to the Chicago Mercantile Exchange, the total trading volume in the feedstock market in November 2018 was just 1,365 trades. This number expresses how many contracts were bought and sold for the right to buy or sell forage cattle.
Meanwhile, the oil market clashes with public and private sector drilling companies, service companies such as BP and Shell, airlines that actively buy and sell oil to keep their fuel costs in check, and speculators. The Chicago Mercantile Exchange put the total trading volume for crude oil at 866,628 in December 2018, a vast difference from the fodder cattle.
Agricultural raw materials
One of the most popular drinks in the world is coffee, with 2.25 billion cups drunk daily. This is one of the reasons why coffee is so popular with commodity traders. After crude oil, coffee ranks second among the most traded commodities.
Both white and raw sugar are similarly popular. Although many of us think of sugar as a sweetener, it also plays a vital role in ethanol production. The market is projected to grow to $89.24 billion by 2024 at a compound annual growth rate of 2.9%.
Crude oil is popular with traders as it has high volatility, i.e, The turbulence in the wake of the Corona crisis was clearly demonstrated when the price for a barrel of the WTI variety even slipped into the red.
The market, dominated by Saudi Arabia, Russia (until recently), the USA, and China, is susceptible to political events.
Demand for crude oil is high outside of times of crisis as it is used for transportation, plastics production, synthetic textiles, fertilizer, computers, cosmetics, and many other products. The main grades are WTI and Brent.
However, natural gas is used in commercial, private, and industrial environments, for example, in energy production. The largest natural gas producers are Gazprom, Royal Dutch Shell, ExxonMobil, PetroChina, and BP.
Metal raw materials
Another trendy commodity is gold. Known as a safe haven investment, investors turn to gold when other markets are in turmoil. That is why gold is also inversely correlated with the US dollar.
In addition to investing in gold, investing in silver is also becoming increasingly popular. Silver prices tend to move much faster than gold prices, making them attractive to active traders. Gold is more valuable and, therefore, more interesting for long-term investors.
Another interesting raw material is lithium. The bright light metal is also known as “white gold” because of the difficulties in extracting it and is mainly used in manufacturing batteries and accumulators. After a sharp slump between 2018 and 2020, lithium shares are showing a steady upward trend, which can be attributed to the increasing interest in electromobility and the energy and transport transition required worldwide.
The last metal raw material we would like to present here is copper. This benefits from a consistently high demand generated in the areas of electrical equipment, engineering, installation, and cooking utensils. The price of copper is considered a reliable barometer for the global economy, which is why investing in copper is a bet that global GDP will increase in the future.
However, when trading commodities, it is also essential to understand how commodity prices are formed and how these price movements can be traded. We want to look at that in the following section.
Brent and WTI crude oil
The first two entries on our list should be no surprise, even to those unfamiliar with commodities trading. Crude oil is still in high demand as it powers our cars, heats our homes and produces fertilizers, pesticides, and plastics.
Brent is one of two benchmark interest rates, the other being WTI crude. Both Brent, a benchmark in Europe, and WTI, a benchmark in the United States, depend on global supply and demand but are also particularly sensitive to geopolitical events.
An example of this was the last week of February 2022, when oil prices spiked due to the war started by Russia in Ukraine. These events pushed Brent prices above $100 a barrel for the first time since 2014. WTI also recorded its highest level since 2014, touching $100. Was this a good time to invest in commodities?
Natural gas is an important global energy source that is found deep below the earth’s surface. Despite being a non-renewable energy source, natural gas is by far the cleanest-burning fossil fuel and is very versatile, serving many of the exact needs as crude oil.
The International Energy Agency (IEA) estimates that demand for natural gas will increase by 30% by 2040, reflecting the global importance use of this fuel.
What affects its price if we want to invest in commodities? As with oil, demand for natural gas tends to increase during periods of strong economic activity, pushing up the price. In times of weak economic performance, the opposite occurs.
Other factors that influence the price are natural disasters that can threaten the supply, or again geopolitical events like the war in Eastern Europe. These tensions have pushed up natural gas prices as Russia is one of the world’s largest gas producers and distributors.
A coveted precious metal for centuries, gold is now primarily used to make jewelry and as an investment vehicle. It is mainly mined in China, Australia, Russia, and the United States.
It is considered a safe haven as it tends to rise in price during periods of economic and political turmoil. Therefore, in times of uncertainty, investors tend to divert their money to other investments, such as safe-haven assets like gold.
What affects the gold price?
Demand for gold tends to increase during periods of economic uncertainty, which can increase the price. Additionally, trading gold can be used to hedge against inflation or currency devaluation, meaning its price tends to be an inverse of the US dollar.
At the time of this article update (March 14, 2022), amid uncertainty surrounding the Russia-Ukraine war, the price of gold rose: the price surpassed $2,000 and was close to its all-time high of August 2020 ($2,063).
Silver is also a precious metal historically sought after by mankind. Unlike gold, about half of silver’s demand comes from industrial applications such as solar panels and electronic products.
However, as with gold, much of its demand is controlled by jewelers and investments. While silver is also considered a safe haven asset, it is not considered as reliable as gold because gold’s value is less dependent on the industry.
What affects its price? As we mentioned earlier, silver is a safe haven asset and as such its price will often rise during times of economic or geopolitical turmoil. Silver is mostly mined from the ores of other metals, meaning fluctuations in the price of those other metals can also affect silver trading. Let’s see how the conflict in Eastern Europe has affected its price in the chart below:
Copper is a significant metal in the modern world. Because it is an excellent conductor of electricity and heat, it is widely used in the electronics and construction industries. Chile is a significant producer, accounting for 28% of total world copper production in 2019. Peru, China, and the US, to name a few, are also important producers.
What affects its price? Due to its use in production, the price of copper is highly dependent on economic performance; hence the demand for the base metal is considered a reliable indicator of economic health.
Emerging markets, which are developing rapidly, account for a large portion of the copper market due to their increased need for new housing, transportation infrastructure, and electronics. A slowdown in growth in emerging markets can have a strong negative impact on copper prices and vice versa.
The price of copper, unlike gold or silver, has been falling since mid-February, when Russia started the military activity in Ukraine. In this case, the possibility of a fall in demand due to the conflict and the economic slowdown will negatively impact the metal price.
With an estimated consumption of 2.25 billion cups per day worldwide, it should come as no surprise that coffee makes our list of the most traded commodities. Coffee beans are grown in more than 50 countries in the so-called “coffee belt,” with Brazil being the largest producer.
There are two main varieties that account for the bulk of coffee production: Arabica and Robusta. Arabica coffee is generally considered to be of higher quality, making it more popular and accounting for around 60% of all coffee consumption.
Regarding commodity trading, Arabica tends to have more stable prices, while Robusta prices are generally more volatile.
What affects its price? The price of agricultural commodities, also known as soft commodities, can be strongly influenced by weather conditions. Unfavorable conditions will hamper production, reducing global supply and thus increasing prices. Of course, the opposite also applies.
More than 65% of coffee is produced by just five countries (Brazil, Vietnam, Colombia, Indonesia, and Ethiopia), meaning that if there is political or social upheaval in any one of those countries, global supplies can be drastically affected. The coffee markets usually react very quickly to adverse events in the producing countries.
Despite its high global consumption, coffee is not a necessity. This means global demand can rise or fall depending on economic health.
Sugar has long been a coveted commodity. Its use in food and beverages worldwide, as well as other lesser-known uses such as medical devices and beauty products, makes sugar one of the most traded commodities on the market.
What affects its price? Although sugar is much more accessible these days, it’s still considered a luxury commodity, meaning that, like other commodities on this list, its demand, and therefore price, tends to be positively correlated with economic performance.
In most developed countries, the health problems related to excess sugar consumption are well known, which is a factor that may lead to a drop in demand and lower prices in the future.
The 3 most important reasons for trading commodities
There are many good reasons to start trading the commodity, but three are particularly important. They are:
- Growing world population
- Inflation hedging
- Portfolio diversification
How population growth affects commodity trading
World population growth has exploded since the beginning of the 20th century. Almost eight billion people live on earth today. The annual growth rate, despite slowing down, is around 1%, which means that the world’s population will continue to grow.
Population growth entails increased demand for functioning infrastructure, which could lead to a rise in metal and energy commodity prices. However, the simple calculation “more people equals more hunger” means that the demand for agricultural raw materials is also increasing.
This is how commodities can hedge against inflation
The inflation rate indicates how much the price of certain goods has increased over a certain period of time. In short, high inflation means that the same amount of money can buy less in the future. This means spending more money to get the same amount in terms of commodities.
However, by investing directly in commodities, resourceful traders can protect themselves from these price increases and potentially benefit from selling the purchased commodities later and at a higher price.
How to diversify your portfolio with commodities
Many investors need a diversified investment portfolio. In many Western countries, a household’s entire wealth is invested in one property. If someone decides to invest elsewhere, they usually choose stocks or bonds.
The problem with this is that if the market you invest in crashes, your portfolio will take a significant hit. However, suppose you have invested in several different asset classes. In that case, the individual investments in the collapsed markets will be affected but can be cushioned by the investments in markets that have remained stable. You can achieve such risk diversification by investing in commodities.
Investing in physical commodities
One way to invest in commodities is to go straight to the source and buy the commodity you want, such as oil, gold, or sugar. If the price of the purchased commodity then rises, you could find a buyer and post the difference to your purchase price as a profit.
However, it is difficult to imagine going to an oil seller and buying the commodity as a private individual. They would have to finance the transport and, above all, the storage, which in the case of oil, is subject to stringent requirements. The cost of doing this can quickly eat away at the potential profit you are trying to make from this business.
Sugar producers, meanwhile, only sell in units of 112,000 pounds, about eight times the weight of an adult elephant. Where exactly do you want to put these eight elephants? Also, volatility in commodity markets is typically higher than in stocks or bonds because the price is more affected by supply and demand issues. The price could therefore crash before you profitably sell your goods.
Commodity trading via futures
Futures are contracts in which a seller agrees to sell a specific amount of a commodity to a buyer at a specific time in the future. The buyer, in turn, agrees to a fixed price, which he must pay to the seller at the agreed time.
In the past, the raw materials changed hands at the end of the contract. Today, however, many traders use futures to speculate on the direction of commodity prices. You have no intention of receiving the goods when the contract expires. If the commodity price increases between the date of purchase and the contract’s expiry date, the trader can sell the contract at a profit. On the other hand, if the price falls, it suffers a loss (by the way, this is how the negative WTI price came about in April 2020).
One benefit of commodity futures is the use of leverage, allowing traders to bet more than they own. For example, if a futures contract is offered with leverage of 1:10, this means that the trader can move ten times the amount of commodities with every euro invested. This can multiply the potential profit but also the loss.
While leverage makes futures trading attractive for beginners, overall, futures are very complex instruments as there are many factors to consider when trying to understand how market prices are formed and predict how they will move in the future. For example, one needs to know the market price, storage costs, and interest rates.
Commodity trading via options
Like futures, options are derivatives that allow traders to bet on changes in the price of a commodity without actually owning that commodity. Leverage is also available in options trading. There are two types of options: puts and calls.
The holder of a call option has the right, but not the obligation, to buy a commodity futures contract at a specified price (the strike price) on or before a specified date (the expiry date). However, the holder of a put option has the right, but not the obligation, to sell a futures contract at the strike price on or before the expiry date.
If the futures price rises above the strike price, a call option can be sold at a profit. The opposite is valid for a call option: the futures contract price must fall below the strike price. In their strategy, options traders must, therefore, consider how the market price changes and when these changes occur.