Commodity market basics

Introduction: what is the commodity market?

The commodity market is a collective term for multiple markets, each specialising in different types of goods like energy, metals, and agricultural products. There is not one commodity market, but several, with individual markets for each of the main commodities or groups of commodities. In this diverse group of financial markets, buyers and sellers deal in different commodities – that is, standardised, interchangeable lots of real goods. Commodity trades don’t always involve physical movements of a commodity, and a majority of commodity trading takes place in futures and forwards markets in the derivatives market.

What are commodities?

Commodities are basic resources interchangeable with another example of the same commodity. For example, timber cut to specified lengths and meeting a minimum quality standard is a commodity. However, the same timber used in a carved table is not; it is no longer interchangeable with each unit of cut timber. Once commodities are used in manufacturing, they cease to be standardised lots, and they become goods. For this reason, commodities are often referred to as raw materials. All commodities can be used in further manufacturing, although some are stored for their value, especially precious metals. A few can be consumed immediately, such as sugar or some energy commodities.

What is the role of the commodities market?

The organised commodities market plays a large and important role in the global economy, both in facilitating trade and defining and protecting standards for commodities. Commodity exchanges are responsible for developing the contracts that ensure interchangeability between different examples of the same commodity. For example, gold bullion, one of the most traded safe haven contracts, requires a minimum purity of 99.5% and must be in a bar, not coin form. Most gold derivative contracts are based on the spot price of gold bullion.

What is commodity trading?

Because the commodity market involves diverse sub-markets, you need to understand a few different types of commodity. Some commodity trading is standardised on an exchange, for example the London Metal Exchange (LME) which provides standardised trading for industrial or base metals such as copper, nickel, and iron. Other commodities trade over the counter (OTC), usually more exotic or illiquid commodities such as rare earth metals. Many agricultural commodities are traded OTC.

Different types of commodity markets

Exchange traded commodities

Exchange traded commodity contracts are normally more liquid than OTC commodities, and include most of the major contracts. Although the customer base of commodity exchanges is global, these institutions are physically concentrated in a few cities – Chicago for agricultural commodities, New York, Shanghai and London for metals, and Dubai, New York and London for oil. These exchanges provide a low-risk, liquid trading environment for clients.

Agricultural commodities

What are agricultural commodities, and where do they trade? The main agricultural commodity contracts are exchange traded, with different commodity types on different exchanges. Chicago is the world’s key centre for agricultural commodity trading, with the Chicago Mercantile Exchange (CME) and the Chicago Board of Trade (CBOT) responsible for many contracts on agricultural products as well as exchange traded financial derivatives. Some specialised commodities, such as sugar, trade on exchanges in New York and London.

Industrial commodities: energy and metals

What are industrial commodities? This is a broad group of commodities used in heavy industry and manufacturing. The main divisions are energy commodities, which include oil, gas and its derivatives, and metals. Most of these commodities are exchange traded, with metals trading focused on the London Metals Exchange for international contracts and the Shanghai Futures Exchange for domestic Chinese buyers. Precious metals, which have different price characteristics to base or industrial metals, trade mostly in New York. Energy trading takes place on different exchanges depending on the location of the producer – North American oil, standardised as WTI contracts, trades on the New York Mercantile Exchange, while traders track the Brent Crude oil rate on the Intercontinental Exchange in London. The Dubai Mercantile Exchange is the home market for Middle Eastern oil suppliers. Each of these exchanges sets different contract sizes and is responsible for clearing and settlement on the exchange.

Over the counter commodities

OTC commodity markets connect buyers and sellers directly, off exchanges, and exist for most of the markets described above. This is due to the dominance of derivative contracts in commodities trading, with futures and forwards the most common way of trading commodities. Futures are exchange traded contracts, but forwards, which in many markets make up a majority of trading volume, are OTC. Forward contracts are very similar to futures (they both oblige the buyer to buy a set amount of a commodity on a set date), but offer more flexibility in terms of contract size and terms.

Oil and energy

OTC trading is very important in the oil market, where it accounts for over 50% of total volume. Both forwards and swaps (agreements to exchange a cash flow or commodity, similar to CFDs) are used to trade oil, and forwards are the normal tool for ensuring physical delivery. The big players in the OTC oil market include airlines, refineries, and manufacturers.

Precious metals

Precious metals trading takes place both on exchanges and OTC. OTC trading often involves derivatives such as forwards or swaps, and allows greater flexibility in contract size than standardised, exchange traded contracts. As with the energy market, clients taking physical delivery often access the precious metals market through OTC derivatives.

Commodity market times

The commodity trading day is complicated, since there are many different exchanges and a large portion of trading takes place OTC outside of the main exchanges. Also, unlike the FX or stock markets, there is not the same continuous shift pattern of different exchange trading windows, with volume instead concentrated on one or two locations. In order to service customers worldwide, most exchanges have a very long trading day, often 23 or 24 hours, allowing for continuous electronic trading. Even so, liquidity peaks at the beginning of major sessions. A rough guide to the most liquid market hours is as follows:

London Bullion Market, Intercontinental Exchange: Brent crude oil, precious metals.

ICE trades from 3am GST on Monday through to 2am Saturday (11pm to 10pm GMT), with a one hour break each day from 10-11pm. Liquidity peaks around 9am GMT, 1pm GST.

COMEX, New York Mercantile Exchange: Oil, natural gas, metals.

These markets run from Sunday 6pm EST to Friday 5pm, with a one hour break each day between 5pm and 6pm. In GST the hours are: Monday 2am – Saturday 1am. The one hour daily break falls between 1am and 2am GST.

Commodity market participants

What is commodity trading? It depends on the intentions of the trader. Commodity markets join two main types of participants – speculators, and hedgers.

Speculators

Speculators are traders, taking out positions to try and ride price movements and profit off their initial investment. Some speculators, especially in precious metal markets, might take physical ownership of a commodity, but the vast majority close out their forward or future positions to prevent delivery. All commodity CFD traders are speculators, even if they are hedging a trading portfolio.

Hedgers

Hedging has a specific meaning in commodity trading that is narrower than its general market definition. Commodity hedgers are the producers, transporters and manufacturers who depend on raw commodities for their operations. They will lock in prices for their goods using derivatives, allowing them to plan ahead for their business operations.

How do hedgers and speculators interact in the commodity market?

Speculators and hedgers ensure prices are discovered and trades can be executed, with speculators providing the necessary liquidity for hedgers to execute their trades.

Trading commodity CFDs: steps to getting started

We have looked at how the commodity market works, how hedgers and speculators drive prices. To get active in the commodity market you need to follow some simple steps:

1. First, you need to know the different assets and markets that make up the commodity market. If you are interested in a specific commodity, understand how and where it is traded, what the standard contract is, and whether it is exchange traded or OTC. You should also have a strong understanding of what commodity CFD trading is, and how it works.
2. Next, you need to open a demo or live account. Demo accounts allow you to familiarise yourself with commodity price action without risking any of your capital, while live accounts put you in the action and allow you to trade with real funds.
3. Demo traders: Once you have a trading strategy you are happy with in a risk-free demo account, you can open and fund your trading account and begin live trading in the commodity markets.

Relation to other markets and price action

Commodity markets have differing price action depending on the commodity being traded. Supply and demand is the most important driver in these markets, so for each commodity you need to have some understanding of its industrial users and main producing countries.

Energy markets

Energy markets are influenced by overall demand, driven by industrial and technological change and supply from oil-producing countries. This can be influenced by international agreements. Arguably a risk on asset, there is not a consistent relationship between stock prices and the energy market, and recessions can be associated with both very high and very low oil markets. The Brent crude oil rate is the main international measure of oil prices.

Metals markets

The metals market is divided into precious metals – gold, silver and platinum – which are safe haven assets. Long gold is a classic example of a risk off trade. The other main group are base metals, or industrial metals. What are industrial metals? These are the non-precious metals used in manufacturing – tin, iron, nickel, etc. Their price action is determined by industrial demand and tends to be stronger during periods of manufacturing strength. China is one of the most important suppliers and consumers of base metals.

Agricultural markets

Agricultural markets, including grains and ‘softs’ like coffee, have stable demand thanks to the world population’s continual need for food. Manufacturing, such as grain for biofuels, also has some influence on agricultural commodity prices. Supply is the most important factor here, and weather conditions in producing countries, which include much of South America, especially Brazil, Russia, and the US.

Risk management in commodities

Risk management in the commodity markets follows the same principles as other financial markets. Because commodities are relatively volatile, and in some cases illiquid, more stringent controls are sometimes necessary than in forex or stock trading. Commodity trading in the UAE relies on stop losses, balanced position sizing, and overall portfolio diversification to avoid downside risk.

Conclusion

The commodity market is a broad set of different markets with many opportunities for CFD traders. Whether you are interested in safe haven assets such as gold and silver, important manufacturing materials like base metals or energy, or specialised agricultural commodities, these diverse markets offer unique opportunities. The best way to familiarise yourself with commodity trading is to start practising, and there is no better way to learn commodity trading in the UAE than opening a trading account with ADSS today.

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