How to trade commodities

What is the commodity market?

Commodities are a sometimes-neglected financial asset class, but they can offer many opportunities to traders. Compared to other classes, such as stocks or bonds, commodities are incredibly diverse and include some of the most important drivers of the real economy, from the food we eat to the energy we use to live. CFD traders are highly active in commodity markets, since these contracts allow them to avoid physical delivery, which tends to be difficult for retail traders.

Trading in commodity markets requires an understanding of the different industrial, agricultural, and energy markets that they act in, and their price action follows a different trajectory to global equity markets. That makes them an ideal way to diversify your portfolio, and traders who want to expand their breadth of trading can consider these varied and dynamic markets.

“Commodities are divided into groups, including energy, agricultural commodities, and industrial and precious metals”

What are commodities?

Commodities are basic goods that are widely used, where each unit cannot be differentiated from another. For example, a barrel of Brent crude oil is a barrel of Brent crude oil, interchangeable with any other. To ensure commodities are interchangeable, markets place minimum standards on key commodity contracts. Some commodities, normally metals, have a single standard, normally a minimum purity level, whereas others, especially agricultural commodities such as sugar, have several. The main commodity contracts are traded in huge quantities, with a significant amount of paper trading, where traders do not take physical delivery of the underlying asset. CFD contracts are one way to achieve this.

What are the most important commodities?

Commodities are divided into groups, including energy, agricultural commodities, and industrial and precious metals. Energy commodities include crude oil as well as oil products such as heating oil or fuel oil. Agricultural commodities include wheat, sugar, and coffee. Metals are often divided into industrial and precious metals, and the two markets have different price characteristics and their underlying contracts trade on different exchanges. Industrial or base metals include copper, tin, and iron, which are used mostly in secondary manufacture. Precious metals like gold, silver and platinum also have industrial applications, but a large portion of their use is for jewellery or investment. The most traded precious metals have price characteristics in common with major forex pairs, with greater liquidity and reduced volatility compared to industrial metals. ADSS traders have access to CFDs on all the major commodities contracts across the three groups.

How to invest in commodities?

Investment in commodities normally involves precious metals, as the other industrial and agricultural markets are volatile. That makes them more suitable for day trading rather than taking out long-term positions. The main investment commodities are gold and silver, which can be used as hedges against market volatility, as they are both classic safe haven assets. In theory, when equity markets go down, investors move into a risk off investment strategy that rebalances towards precious metals, high-rated government bonds, and safe haven currencies such as the US Dollar or Swiss Franc.

Trading commodities for beginners: supply and demand

Commodities are normally traded, rather than invested in. Commodity markets move because of supply and demand, with production of commodities concentrated in a few regions and then distributed worldwide in complex logistics operations. That means disruption to supply chains, output of producing nations, and geopolitical developments can all influence commodity prices.

Key industrial commodities such as oil are particularly sensitive to the output of oil-producing nations, and the supply of some base metals is heavily concentrated. For example, 30% of the world supply of copper comes from Chile, with 5% of global production coming from a single mine, the high-altitude Escondida complex. Local political events, natural disasters, or worker disputes can therefore cause extreme volatility in concentrated markets. This creates opportunities for traders to take out long and short positions.

Commodity demand and supercycles

Demand for commodities is more predictable than supply. Generally, global economic growth increases the demand for industrial commodities. When more houses are being built and connected to electricity, more copper is used in wires, and more oil used for energy. The richer people are, the more food they will buy, and agricultural commodities will increase in price. That means commodity demand cycles tend to follow global economic trends, but changes in supply can cause dramatic volatility.

Some analysts believe industrial commodities follow a supercycle, a roughly 30-year trend of major increases and subsequent falls in commodity prices. Their reasoning is that industrial growth drives up the price of key commodities, but that it takes time for drilling and mining operations to improve supply to catch up. This creates sharp price spikes as industrialists struggle to buy enough commodities for their operations. Once suppliers have caught up with demand, by opening new mines, wells, or farms, the overall market has often cooled, resulting in a glut of supply and falling prices. The resulting price pattern is a long term one of boom and bust, and if traders can identify this underlying pattern it will help to guide their shorter-term positions within the trade.

Risk management in commodity trading

Commodities are more volatile than other common assets like forex or bonds. This volatility makes risk management in stock trading especially crucial when dealing with commodities. To effectively manage risk, traders should employ strategies such as setting stop-loss orders, diversifying their portfolio, and using proper position sizing. Understanding what the commodity market is and how it behaves is essential for implementing effective risk management strategies. Traders should also stay informed about global economic trends, geopolitical events, and supply chain disruptions that can impact commodity prices, including the presence of supercycles. Trade-specific news sites and specialised financial media often run explainers on market disruptions, and these can help augment purely technical strategies in commodity CFDs. By using common risk management techniques, traders can protect their investments while capitalising on the potential gains in the commodity market.

Conclusion

Learning how to trade commodities will help you understand the global economy and make better decisions in trading. With many markets to choose from, including energy, agricultural, and metal commodities, commodities is a broad space that allows many opportunities to get involved in markets, using both technical and fundamental strategies. Commodity markets follow the same technical patterns and show the same influence of supply and demand as other financial markets, but they are unique in terms of their impact on the real economy. That means understanding what commodities are and how they function in the global economy is crucial for success in this market.

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