How to Trade Commodities (Part 1/2)
It is generally thought that commodities trading began as far back as 6,000 years ago in China, with rice futures. Many countries throughout the millennia have gone to war over commodities, as their nations sought out precious resources from foreign lands. Commodities markets are governed by a wealth of supply and demand factors which affect their value. Consider the oil price slump that began in late 2014 as a case in point. For Western nations, the price of crude oil is particularly important, and this is reflected in the energy sector of international stock exchanges. As the price of commodities like crude oil increases, the oil rich countries producing this commodity benefit. Conversely, falling crude oil prices negatively impact the fortunes of oil producing companies. Price volatility is further hampered by natural phenomena, geopolitical factors and technological innovation.
How to Trade Commodities (Part 2/2)
There are essentially four categories of commodities available: agricultural commodities, livestock & meat commodities, metals and energy. Agricultural commodities include the likes of rice, corn, cocoa, coffee, sugar and cotton. Livestock and meat include feeder cattle, pork bellies, live cattle and lean hogs. Metals include platinum, gold, silver and copper, and energy commodities include gasoline, heating oil, crude oil and natural gas. Owing to the widespread disparities in quality among commodities, there has to be a standardization method for the purposes of ensuring that all the available commodities meet the same high quality standards. Commodities can be divided into soft commodities such as agricultural produce and hard commodities such as crude oil and natural gas. Nowadays, many commodities traders do not typically take physical delivery of commodities that they trade.
Futures Contracts and Commodities Trading (Part 1/2)
It is relatively easy for investors to get involved in commodities trading. One of the most popular ways to invest in the commodities market is a futures contract. This is essentially an agreement to buy or sell a set quantity of a specific commodity at a specific price in the future. Institutional traders and commercial traders are a large component of the futures markets. They hedge their positions in an attempt to reduce their overall level of risk when price changes occur.
Futures Contracts and Commodities Trading (Part 2/2)
The other group of commodities traders – composed largely of individuals – are known as speculators. They close their positions before contracts are due and never take delivery of the actual commodity. If you are interested in getting involved in futures contracts, you will be required to open a brokerage account. You will realize gains if after you sell an asset the price falls. You can also realize gains if you purchase an asset and the price of that asset rises. When you hedge your position you’re taking an opposite position in addition to the one you originally took, to protect yourself in the event that the market moves against you.
Characteristics of Commodities Trading (Part 1/2)
Commodities feature three distinct characteristics: tradability, deliverability and liquidity. All commodities need to be tradable and there must be an investment vehicle to help you make that trade. All commodities also need to be physically deliverable. If we take the case of crude oil, it is delivered in barrels. Likewise wheat is delivered in bushels. Commodities need a degree of liquidity in order for traders to get in and out of trades. With the exception of natural gas, gold and oil, many commodities experience periods of lower liquidity.
Characteristics of Commodities Trading (Part 2/2)
That is why commodities are traded on exchanges, to ensure that trades can take place smoothly. Remember that commodities are typically traded up to 5:00 PM EST Eastern Standard Time on the New York Mercantile Exchange (NYMEX). Commodities prices are heavily affected by myriad factors as outlined earlier, and depending on how much exposure a country has to its leading commodities, its economic fortunes could be closely tied to commodity prices.
Risks of Trading Commodities (Part 1/2)
When you make an investment, you are taking a calculated risk that the future return will exceed the present investment. With commodities, there are several risk factors to bear in mind. These include geopolitical risks, speculative risks and delivery risk. Geopolitical risks relate to governments and their control over natural resources, companies and other power players in the market. Things like licensing agreements, environmental concerns and tax structures are key components of geopolitical risks. In the natural gas industry, nationalization of a country’s resources can have dramatic implications on the profitability of owning commodities, as was the case with Bolivia in 2006.
Speculative risks are an intractable component of the commodities markets.
Risks of Trading Commodities (Part 2/2)
Speculators are traders seeking short-term profits and they do this by speculating on price movements of securities. Speculators inject liquidity into the markets but they also increase market volatility. In the commodities markets, there is an estimated 25% speculator component and a 75% commercial user component. Delivery risk can be defined as fraud and other issues that can impede delivery. Investors need to be assured that the commodities they are investing in are secure. Thorough research and due diligence can save you a whole lot of hassle when it comes to delivery risk, but the risks can never be completely eliminated.