For investors, commodities can be an important way to diversify their portfolio beyond traditional securities. Because the prices of commodities tend to move in opposition to stocks, some investors also rely on commodities during periods of market volatility.
In the past, commodities trading required significant amounts of time, money, and expertise, and was primarily limited to professional traders. Today, there are more options for participating in the commodity markets.
A History of Commodities Trading
Trading commodities is an ancient profession with a longer history than the trading of stocks and bonds. The rise of many empires can be directly linked to their ability to create complex trading systems and facilitate the exchange of commodities.
In modern times, commodities are still exchanged throughout the world. A commodities exchange refers both to a physical location where the trading of commodities takes place and to legal entities that have been formed in order to enforce the rules for the trading of standardized commodity contracts and related investment products.
Some commodities exchanges have merged or gone out of business in recent years. The majority of exchanges carry a few different commodities, although some specialize in a single group.
Special Characteristics of the Commodities Market
In the broadest sense, the basic principles of supply and demand are what drive the commodities markets. Changes in supply impact the demand; low supply equals higher prices. So, any major disruptions in the supply of a commodity, such as a widespread health issue that impacts cattle, can lead to a spike in the generally stable and predictable demand for livestock.
Global economic development and technological advances can also impact prices. For example, the emergence of China and India as significant manufacturing players (therefore demanding a higher volume of industrial metals) has contributed to the declining availability of metals, such as steel, for the rest of the world.
Types of Commodities
Commodities that are traded are typically sorted into four categories broad categories: metal, energy, livestock and meat, and agricultural.
Metals
Metals commodities include gold, silver, platinum, and copper. During periods of market volatility or bear markets, some investors may decide to invest in precious metals–particularly gold–because of its status as a reliable, dependable metal with real, conveyable value. Investors may also decide to invest in precious metals as a hedge against periods of high inflation or currency devaluation.
Energy
Energy commodities include crude oil, heating oil, natural gas, and gasoline. Global economic developments and reduced oil outputs from established oil wells around the world have historically led to rising oil prices, as demand for energy-related products has gone up at the same time that oil supplies have dwindled.
Investors who are interested in entering the commodities market in the energy sector should also be aware of how economic downturns, any shifts in production enforced by the Organization of the Petroleum Exporting Countries (OPEC), and new technological advances in alternative energy sources (wind power, solar energy, biofuel, etc.) that aim to replace crude oil as a primary source of energy, can all have a huge impact on the market prices for commodities in the energy sector.
Livestock and Meat
Livestock and meat commodities include hogs, pork, live cattle, and feeder cattle.
Agriculture
Agricultural commodities include corn, soybeans, wheat, rice, cocoa, coffee, cotton, and sugar. In the agricultural sector, grains can be very volatile during the summer months or during any period of weather-related transitions. For investors interested in the agricultural sector, population growth–combined with limited agricultural supply–can provide opportunities for profiting from rising agricultural commodity prices.
Using Stocks to Invest in Commodities
Many investors who are interested in entering the market for a particular commodity will invest in stocks of companies that are related to a commodity in some way. For example, investors interested in the oil industry can invest in oil drilling companies, refineries, tanker companies, or diversified oil companies. For those interested in the gold sector, some options are purchasing stocks of mining companies, smelters, refineries, or any firm that deals with bullion.
Stocks are typically thought to be less prone to volatile price swings than futures contracts. Stocks can be easier to buy, hold, trade, and track. Plus, it is possible to narrow investments to a particular sector. Of course, investors need to do some research to help ensure that a particular company is both a good investment and commodity play.
Investors can also purchase options on stocks. Similar to options on futures contracts, options on stocks require a smaller investment than buying stocks directly. So, while your risk when investing in a stock option may be limited to the cost of the option, the price movement of a commodity may not directly mirror the price movement of the stock of a company with a related investment.
An advantage of investing in stocks in order to enter the commodities market is that trading is easier because most investors already have a brokerage account. Public information about a company's financial situation is readily available for investors to access, and stocks are often highly liquid.
There are some relative disadvantages to investing in stocks as a way of gaining access to the commodities market. Stocks are never a pure play on commodity prices. In addition, the price of a stock may be influenced by company-related factors that have nothing to do with the value of the related commodity that the investor is trying to track.
When trading commodities, liquidity should be the number one factor to consider. This is because the liquidity of a commodity is linked to the ease with which a trader can Buy and Sell the commodity. To put it simply, liquidity is a measure of how many buyers and sellers are present and whether transactions can take place easily.
When there is a significant level of trading activity and where there is both high supply and demand the relevant market would be very liquid. A liquid market is generally associated with less risk, as there is usually someone else willing to take the other side of a position. High liquidity also means less probability of slippage for the trader.
Slippage is defined as the difference between the price quoted to the trader and the actual price at which the trade is executed. Slippage can work both in your favour and against you - for example, trading in commodities with low liquidity could potentially lead to greater losses.
In addition, commodities with low liquidity often face sharp price swings. As such, if you are looking to trade the commodity market, you should try to focus on commodities with high liquidity. Some of these highly liquid commodities include energies such as Oil, Natural Gas, precious metals such as Gold and Silver and agricultural products such as Cotton, Soybeans and Wheat (i.e., commodities with high trading volumes).
One way to manage liquidity risk is through the use of guaranteed stops, a type of stop-loss that ensures your position is closed at your pre-selected price level.
Most Actively Traded Commodities
Crude Oil
Crude oil is one the world’s most in-demand commodities as it can be refined into products including petrol, diesel and lubricants, along with many petrochemicals that are used to make plastics. Brent crude is one of the two major types of oil used to benchmark global prices, along with West Texas Intermediate (WTI). It is a high-quality ‘sweet light’ oil, meaning it has a low sulphur content and density, and is therefore relatively easy to refine into usable end products. It is drilled from oil fields in the North Sea’s Brent, Oseberg, Forties and Ekosfisk fields, off the shores of the UK and Norway. This proximity to the coast makes it relatively cost effective to transport internationally.
Like all commodities, the price of Brent crude is dependent on supply and demand factors. Historically, demand for oil has been correlated with global economic performance. Prices generally rise during boom periods – as more oil is needed to manufacture and transport products – and fall during economic slowdowns. On the supply side, global supplies of oil – rather than the supply of Brent crude specifically – has the most influence over this commodity’s price. Here the Organisation of the Petroleum Exporting Countries (OPEC), which sets production quotas for member countries, has historically had a great deal of influence. However, this has waned in recent years as the US, which is not an OPEC member, has increased shale production.
Aluminium
Aluminium is another best commodity to trade as it is a lightweight metal and is used in various industries.
Aluminium is used in manufacturing industries like automobiles, construction, electronics, etc. and is in huge demand.
The metal is versatile and used in abundance in various industries.
Aluminium is obtained from Bauxite and China is the biggest producer and consumer as well. The prices of aluminium are affected by Chinese demand in the transportation and construction industry.
The cost of making aluminium also varies according to the prices of oil and electricity.
Thus, aluminium becomes a great commodity to trade in as it has a wide score of price fluctuations.
Nickel
Nickel is a lustrous metal which is strong. ductile and resistant to corrosion. It also has a high melting point and catalytic properties. Because of these factors, nickel becomes one of the widely used metals in the industries of the world, thus becoming one of the top commodities to trade in. Nickel has become an integral part of the growing economy as it plays an important part in the electroplating process and in the manufacturing of stainless steel. Because of its worldwide use, nickel is largely affected by the demand and supply and shows significant price movements.
India does not manufacture much nickel but has a high demand as it finds its use in the development of the country.
Nickel is traded on the Indian exchanges like MCX, NMCE and NCDEX but is mainly controlled at the London Metals Exchange and is traded in a lot size of 250 kilograms.
Natural Gas
Natural Gas is a non-renewable hydrocarbon used as a source of energy for heating, cooking, and electricity generation. It is also used as a fuel for vehicles and as a chemical feedstock in the manufacture of plastics and other commercially important organic chemicals.
Gold
Throughout recorded history, Gold (ticker: XAU) has been highly sought after for its beauty as well as a storehouse of value. While the traditional uses of gold have not changed, it nowadays is also regarded as a key component in the manufacture of electronics.
Copper
Like Gold, Copper is widely used in the electronics industry in light of it being a good conductor of electricity. Due to its wide usage in the manufacturing industry, the price of copper can fluctuate according to economic output. The key producers of this metal are Chile, China and Peru.
Silver
Similar to Gold, Silver is highly sought after as a precious metal. However, silver is also widely used in the manufacture of solar panels and photographic films. Although Silver is also regarded as a precious metal, most people prefer gold as it is a more reliable store of value.
The Bottom Line
Both novice and experienced traders have a variety of different options for investing in financial instruments that give them access to the commodity markets. While commodity futures contracts provide the most direct way to participate in the price movements of the industry, there are additional types of investments with less risk that also provide sufficient opportunities for commodities exposure.
In the most basic sense, commodities are known to be risky investment propositions because they can be affected by uncertainties that are difficult, if not impossible, to predict, such as unusual weather patterns, epidemics, and disasters both natural and man-made.
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