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Commodity Trading: What Is Commodity Trading And How Does It Work?

Gold, sugar and oil. How do people actually trade and make (or lose) money from them?

 

Commodity trading is a niche area in the finance world that in recent years has been gaining more interest among individuals who are seeking alternative trading instruments from the usual stocks and bonds.

Types Of Commodities Frequently Traded

Commodities that are frequently traded in the financial markets are typically the ones that drive the global economy world that we live in.

These include important and precious metals such as gold, silver, copper, platinum, and energy commodities like oil and natural gas. Both metals and energies are considered as hard commodities, since they are mined or extracted.

Commodities such as wheat, sugar, corn and cocoa are known as soft commodities. Unlike hard commodities, they are products that are grown, rather than extracted or mined.

Type Of Commodities Examples
Metals Gold, Silver, Copper, Platinum, Aluminium, Lead, Nickel, Zinc
Energies Oil (Brent, Crude), Heating Oil, Natural Gas
Soft Cocoa, Coffee, Corn, Cotton, Soyabeans, Sugar, Wheat

Source: IG, Commodities Trading

AdvertisementRegardless of whether they are hard or soft commodities, the key basis behind why these commodities are frequently traded by traders is because they enjoy a huge global demand, and are needed for the things that people consume or use.

How Commodity Trading Started?

All commodities require time to produce and process before it is delivered from producers to buyers. This gives rise to two main forms of payment that producers and buyers can settle on.

# 1 Spot Price

Spot price is the price you pay for buying the commodity “on-the-spot”. For example, if a corporation wants immediate delivery of a barrel of crude oil today, they will pay the spot price, which is the current market price of the commodity today.

# 2 Future Contracts

If a corporation requires the commodity in the future, but wants to have some future price certainty today, it can enter into a future contract with the producer. This is basically an agreement between the two parties for future delivery of the commodity for an agreed upon price.

Ways To Trade Commodities

Commodity trading in the financial markets work in a similar manner to the two ways mentioned above. Traders can trade commodities based on current spot price (e.g. Spot Gold, Spot Silver) and make, or lose, money depending on whether the price moves for or against their position.

Spot positions have no expiry date, meaning you can hold your position for as long as you want to. This can be done through CFDs.Advertisement

Read Also: What Are CFDs And When Should Traders And Investors Use It?

Traders can also opt for a future contract as well. Unlike a spot position, a future contract will expire at a specified future date. The value of a future contract will be derived by how much the commodity is priced in the future contract, compared to the spot price at that point in time.

Future contracts are highly standardised and traded through dedicated exchange that ensures all contracts are marked-to-market daily.

You can read up on more details about how you can trade commodities either through CFDs or Future in this guide from IG.Advertisement

Risk In Commodities

Similar to all types of financial instruments, there are risks involved when it comes to commodity trading. Here are the 4 main risks that potential traders should be familiar with.

# 1 Demand & Supply

Since all traded commodities are used, the prices of commodities can swing widely based on whether demand excess supply, or vice versa.

For example, if a big country such as China were to expand its infrastructure development over the next few years, prices of traded metals are likely to increase.

# 2 Weather

For soft commodities such as wheat, cocoa and coffee, prices can increase if poor weather limits supply for a particular time period, since consumer demand for these goods are likely to remain constant.

# 3 Political Development

Political developments can cause price fluctuations.

For example, if large oil producing nations in the Middle East are in a political turmoil, it may lead to a slowdown in oil supply, thus leading to oil prices increasing.

# 4 Exchange Rate

Like it or not, most commodities are priced in US Dollar (USD). For Singaporeans, what that means is that the performance of our Singapore Dollar (SGD) against the USD also matters to us, since any potential gains in our trades may be offset if the exchange rate moves against us.

Price Volatility

One of the main reasons why financial traders are keen to trade commodities is because of price volatility.

Due to the various risks mentioned above, prices can fluctuate significantly in the short run thus allowing for profits to be made, assuming a trader takes the right position. By employing leverage, profit margin can increase further.

Read Also: How Does Leverage Trading Work In Singapore

Of course, the reverse holds true as well. Unexpected price volatility can lead to losses for traders who are on the wrong side of the trades. As such, it is important for traders to understand the commodities they trade, and the risks they are exposed to when they trade these commodities. Understanding these risks are what separates knowledgeable traders from those who are blindly speculating on price changes.

If you are looking to read up more about commodity trading, IG has a Advertisementstep-by-step guide to explain how these volatile yet invaluable natural resources fit into the wider trading world. In addition, if you are looking to explore this area of trading, we recommend that you first start off by Advertisementattending some seminars to educate yourself, and to try out a demo account first.Advertisement

This article was sponsored by IG, the world’s No.1 CFD provider (by revenue excluding FX, 2016). All views expressed in the article are the independent opinion of DollarsAndSense.sg

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