Learn how to trade commodities online in this guide to commodities trading. You will also find a complete and up-to-date list of the best online commodity brokers.
Best Brokers for Commodities Trading
The main difference between foreign exchange or equity trading and the commodities market is that the commodities market deals in tangible goods. That is, they are physical products that are normally bought or sold on a financial exchange, e.g. Euronext. However, it is also possible for retail traders to trade the commodity on CFDs (Contracts for Difference).
Commodity trading with CFDs involves a number of risks that you need to be aware of before you venture out and risk your capital. No one likes to lose their investment money, so on this page we are going to take an in-depth look at the world of trading these financial instruments.
What does Commodity mean?
Commodities are raw materials that have a utility and a value. They are products that are abundant in nature and are practically indistinguishable from each other: they have a really low level of specialisation.
What are the best commodities to trade online?
Commodities are subject to various classifications. For the purposes of commodity trading, the main ones are as follows (with one or more examples):
- Precious metals: gold, silver, palladium.
- Other metals: zinc, nickel.
- Energy: crude oil, natural gas, coal.
- Agricultural: coffee, sugar, corn, maize, wheat, soybeans, cotton and cereals in general.
Gold and silver are the most appropriate commodities to invest in, and have the highest online investment volumes. However, the rest can also be profitable and it is not only necessary to focus on one precious metal.
How to trade commodities
There are a priori two ways to trade commodities online and we explain them below.
The most common market for trading commodities. And the basis for this are futures contracts. Contracts in which, at the time of signing, a price, a quantity and an expiry date are already established. The two parties to the business (buyer and seller) establish the commitment to comply with these variables already stipulated in advance. In other words, the buyer commits to buy and the seller to sell a certain quantity, on a certain date and for a certain price.
To start trading commodity CFDs, you need to use a trading platform that works in this financial market. The contract will be concluded by paying an initial deposit and the commodity trading account will be opened. Remember that many brokers offer the possibility to open a demo account with fictitious money.
The commodities market works in the same way as the market for other tradable commodities. It is about making a profit by buying or selling: either you sell for a higher price than you bought it for, or you buy it back for less than you sold it for.
The futures market follows the principle: «Buy now, pay and receive the product later». However, unlike manufacturers, commodity traders are not interested in the product itself, they do not require physical delivery of the product.
This is the nature of CFD trading: you do not own the product, you only trade the movement – in this case – in the price of commodities. This is why it is most common for commodity futures contracts to roll over: the expiry date is delayed, so that the investor does not have to bear the costs of settling the contract.
One of the most striking features of this financial market is that commodity prices vary continuously. This creates a strong market sentiment, which can often open up investment possibilities.
This means, on the one hand, that the value of the aforementioned account fluctuates greatly during the contract’s validity period. But also – mainly due to the high leverage effect of these trading accounts – very small changes in the price are capable of generating huge potential gains or losses. In fact, it can happen that it falls below a minimum value; when this happens, the trading platform asks the account holder to deposit additional funds in order to be able to maintain his position in the market.
There is also the option, in commodity trading, to buy spot: this is the spot market. It is not too much of a mystery, as it is a normal purchase and sale: you pay for the immediate delivery of the raw material (e.g. an agricultural raw material) at the current market price. There are no generally fixed price standards, but prices are set independently and the exchange does not need to be supervised.
Commodities trading tips
Here is our list of tips to help you trade commodities. This is not a trading course but we hope you find it useful.
GET INFORMED AND UPDATED
As in any business in which you are trading, it is absolutely necessary for the investor to always be informed and to keep an eye on movements. When dealing with equities, they can be affected, for example, by takeover threats, market research or quarterly reports. This has nothing to do with the commodities market.
Because commodity prices are subject to sudden fluctuations due to events that are very difficult to predict: weather conditions, livestock diseases, major oil discoveries… Predicting this type of event is sometimes directly impossible, but we must try to do so and, to do so, it is very important to follow the news and forecasts closely. Remember that technical analysis and fundamental analysis are of great help.
In the second half of 2014, the fall in oil prices (a commodity) caused energy stocks (equities) to fall significantly in value. This is just one example of how movements in commodity prices can affect the price of other commodities. It is the chain effect mentioned in the heading of this section.
This has led more experienced investors to use a trading strategy of studying the relationship between the commodity and these other products as a way of predicting future fluctuations. They do this by including a commodity in their portfolio, which allows them to look at the movements that may occur in the companies related to it. However – and this is not a trivial caveat – only the most experienced traders and professional clients can play this trick, as it is very easy to misinterpret the fluctuation of a stock as a response to a change in the price of commodities.
When the storm is raging, the best thing to do is to go to port and shelter until it blows over. But we are not sailors now, we are commodity traders. The extrapolation would be that, in periods of extreme volatility, the best thing to do is to take refuge in certain products that tend to show a certain stability. They are the «safe haven» and, in the commodities market, the safest is gold. This is why many investors, in times of sharp fluctuations, buy this product, which is usually low risk.
INFLATION AND COMMODITY PRICES
Investing in commodities can be a natural defence against inflation. When inflation is imminent, commodity prices rise rapidly. This happens because people withdraw money from investments that lack inflation hedges and invest it in the commodity financial market to protect their portfolios.
Factors affecting commodity trading
The main ones are:
SUPPLY AND DEMAND
Oil is a very clear example: if the quantity of existing oil increases and the level of demand remains the same, this will lead to a decrease in the price per barrel. If the demand for oil increases while production capacity stagnates, then the price per barrel will be higher.
ECONOMIC AND POLITICAL FACTORS
Commodity prices are traded on the futures market and with futures contracts, but this does not prevent events from affecting the price of these commodities. Thus, political instability in parts of the Middle East causes the price of commodity futures such as oil to fluctuate due to the uncertainty of whether production and supply can be realised.
Agricultural assets such as wheat or coffee will be strongly influenced by weather-related factors, as weather significantly affects their production. In years when harvests are low and supply is insufficient, prices will rise.
Commodity prices are usually quoted in US dollars. The relationship between commodities and the US dollar is inversely proportional: a rising dollar is anti-inflationary and puts downward pressure on commodity prices. Conversely, a falling dollar puts upward pressure on commodity prices and commodity prices.
Commodity price indices
If you want to invest in commodities, you need to keep an eye on commodity price indices. These are a weighted average of the prices of a specific type of commodity or group of commodities. The indices can be spot or futures prices. Here are some examples:
- Continuous Commodity Index (CCI): a group of 17 commodity futures that are continuously rebalanced to maintain an equilibrium set at 5.88% for each future. It is used as a benchmark for the performance of these commodities.
- S&P GSCI (formerly Goldman Sachs Commodity Index): its members come from all sectors and, like the previous one, it is a benchmark for trading in the financial commodities market. It is available on the Chicago Mercantile Exchange.
- Merrill Lynch Commodity Index (MLCX): the commodities included in this index have been selected on the basis of their liquidity. The weighting established in this index varies according to the assumed importance of each of the commodities included and their potential impact on the world economy.
In short: Why trade commodities with CFDs?
The two main reasons are high leverage and smaller contracts. The combination of these two factors lowers the initial capital requirements for traders.
However, we must take into account the fact that CFDs are complex instruments and that trading them without a detailed knowledge of them carries a high risk of losing money in the short term.
- Guide to investing in gold