The general public has a solid understanding of several investment vehicles. Bonds are a loan with interest to the government. Stocks are partial ownership of a company. Real estate is an ownership interest in land and buildings. However, one of the most popular investment vehicles, commodities, is not well understood by the public at large.
In this beginner’s guide to trading commodities, we will explain every aspect of commodity training you need to know in order to start your trading journey. You might also be interested in learning more about Forex in our Forex Trading course or finding out how to use the 7 technical indicators for Forex.
People may have invested in commodities without even knowing it — they might have “exposure” to gold or oil values in their portfolios … but they might not know what that means. They might know you can invest in “coffee futures” or “pork belly futures” … but they don’t know exactly what that means. They might even have trouble keeping a straight face when saying “pork belly futures.”
Basically, they know that commodities are a thing you can invest in, but they do not know how to do it, if they should do it, or why they should do it.
Let us strip away some of the mystery and discuss what commodities are, how to invest in them, and when and why you should or shouldn’t invest in them.
This is the Ultimate Beginner’s Guide to Trading Commodities.
What Is Commodities Trading?
A “commodity” is any item of value that exists in a limited supply in the real world. The value of a commodity expands, or contracts based on supply or demand. If the commodity becomes scarce and/or demand increases, the value goes up. If the commodity becomes plentiful and/or down, the value goes down.
Sometimes, “investing” in a commodity is as simple as buying plenty of that commodity and keeping it in your garage, in hopes that the supply collapses or demand skyrockets and the value of your stash skyrockets.
More commonly, though, investing in commodities means trading derivative financial instruments on a financial market. The first organized commodity exchange was created in Amsterdam in 1530. Today you can partner with a broker or brokerage, or form an account online, that trade a variety of instruments that could pay out if the chosen commodity becomes more valuable … or different instruments that pay out if the commodity becomes less valuable.
You can essentially bet on or bet against the increasing value of a commodity like oil or gold. If you can successfully predict the supply of and demand for these commodities, you can profit from those predictions.
What Commodities Can You Trade?
Again, if something is in limited supply and experiences demand, it is a commodity and can usually be traded. Examples include:
Agricultural products form the backbone of many economies. They can include crops that are eaten or fed to animals, but also industrial or textile products like hemp, cotton, and rubber. Examples of agricultural commodities include:
All modern societies depend on energy to thrive and grow their economy. The fuel substances for that energy have been one of the most important commodities of the modern era, to include:
- Heating oil
- Natural Gas
- Crude Oil
Livestock and Meat
There are only so many livestock animals in the world, slaughtered for meat or bred to produce more livestock animals on a limited basis. Livestock and meat commodities include:
- Live cattle
- Feeder cattle
- Lean hogs
- Pork bellies
Various rare metals have significant industrial and technical values. Other metals, like gold, silver, and platinum, have been prized for their beauty and malleability, the physical manifestation of the very idea of money. Precious metal commodities include:
What Types of Commodities Investments Are Available?
There is no one way to “invest in commodities.” Here are some examples of how people invest in commodities:
The Actual Asset
You can just hoard gold, dried rice, or tanks of gasoline on your property. This practice tends to be associated with apocalyptic doom-criers and survivalists, but the economics are sound. If the dollar tanks, the world food supply collapses, or oil peaks and leads to severe shortages, that stash of valuable commodities will suddenly become very valuable. The hoarder might have the only real currency in a world where money is useless paper and every stock portfolio has become worthless.
Of course, this “Wild West” approach to commodity hoarding only works if you can defend your stash which, in the event of the apocalypse, might mean at gunpoint. This type of commodity investing can also be less liquid than more sophisticated instruments. For example, if you stockpile your own stash of gold bullion, you cannot exactly chip off a corner of a gold brick to take to the post-apocalyptic grocery store. You must find someone to buy the whole bar.
Exchange Traded Fund
Most commodity investors buy into an “exchange-traded fund” (ETF). An ETF is an instrument traded on public securities markets that rises or falls with the value of the underlying commodity. It may be a paper instrument tied to the commodity itself, or it may represent a portfolio of stock in the business vertical of that commodity, for instance farming, processing, and distribution companies for an agricultural product.
ETFs are very liquid. You can buy and sell your position at will. It is also a derivative — tied to the asset but separate from the asset. It is like owning that stash of gold or gasoline, but on paper only. You do not have to make room in your garage or be concerned about storage.
If you think you know that a certain commodity’s value will go up or down, you can buy a futures contract for that commodity.
This kind of derivative product allows you to take a long or a short position. If you buy a long futures contract, your investment increases in value if the value of the underlying commodity increases.
If you buy a short futures contract, the value of your investing increases if the value of the underlying contract decreases.
Contract for Difference
Contracts for difference (CFD) are like stock options. You pay the commodity exchange a fee for the right to buy or sell a commodity at a specified price.
A long CFD entitles you to buy a commodity at a certain price. If the value of the commodity goes up, you can buy at the lower contract price, immediately sell at the higher market price, and pocket the difference.
A short CFD bets against the commodity by allowing you to sell the commodity at a set price. If the value of the commodity goes down, you can buy at today’s low price, immediately sell at the contract price, and again pocket the difference.
A CFD is a leveraged investment, meaning you buy on margin and can make outsized returns for a small investment.
Of course, if you bet wrong, your contract expires, the fee is non-refundable, and your investment is a total loss. This compares unfavorably to ETF investments—even if the commodity loses value, your ETM is probably still worth something and might conceivably bounce back.
How Can You Trade Commodities?
Commodities and their derivatives can be bought and sold through most investment brokerages, and on most public trading platforms. The steps are like buying and selling stocks or options:
- Choose your trading platform or brokerage. Diversit-e Smart Trade College has partnered with the “Best Broker in Africa” being an FSCA regulated Broker and Clients’ trading funds are kept in a segregated account. This means that Clients’ trading funds are kept separate from the Broking company’s operational account. Ask us for more information.
- Set up and fund an account.
- Choose the commodity or instrument you wish to trade. Pick a long or short position (if applicable).
- Choose the size of your trade.
- Manage your risk with stop-loss indicators.
- Execute your trade order, either by phone or online.
- If you use a real (live) online trading platform such as MetaTrader 4 or 5, will the platform monitor your open position(s) and should automatically close open positions which ever level, stop-loss or take profit, is reached. Features like these means you do not have to watch and monitor your portfolio 24/5.
When Are Commodities a Potential Profitable Investment?
Some people see commodity investing as inherently risky. They usually mean highly leveraged spread bets where the entire position is worthless if the commodity does not ‘behave’.
However, ETFs and other long-term commodity positions can be an effective way to create a diversified portfolio. Commodity values tend to rise when stock values decline. Whereas some people “diversify” into bonds that will at least hold steady during stock market freefalls, commodities are a “hedge” investment that might gain value rather than hold steady.
The time to buy EFTs and long commodity futures is in booming economies. Commodities tend to be at their lowest prices in boom time, assuming there isn’t a major shortage, and no one discovers that pork bellies actually cure cancer. If the economy corrects or contracts, those ETFs are likely to increase in value while stocks lose value.
Of course, if you know for a fact that the value of a commodity like oil will rise or fall, a long or short commodity derivative could be a great investment, but in commodities there are few sure things. Many people buy stocks, certain that the stock will gain value, but the stock does not always ‘behave’.
If someone does know, based on some deep industry knowledge, that a certain commodity will move a certain way, “insider trading” laws may apply, the same as with stocks.
When Are Commodities a ‘Bad’ Investment?
It is not a bad investment if the investment shows profits. Leveraged commodity trades can be extremely lucrative if you time the market right.
However, leveraged investments always carry with them the risk of a total loss. If you buy a CFD thinking oil is going to tank, but instead it skyrockets, every dime you paid for that contract is lost.
On the more conservative side, commodity ETFs and long positions tend to be bad investments during recessions. At these times, tangible assets like gold, energy, and food tend to be at their highest, with no place to go but down. Stocks and real estate are generally better bets in recessions, because they have usually dipped in value and stand poised to climb.
Compared to stocks and real estate, commodities tend to disappoint over time. Their peaks and valleys follow a flat trajectory, not the upward climb that those inflation-beating stocks and properties tend to track. This means that commodities can be a good hedge against downturns, but do not really work as the backbone of a growth portfolio.
Commodity contracts also have storage, insurance, and transport costs baked into the deal, costs that do not rise or fall with the value of the commodity. This means that your profit potential is blunted by the padding of added costs.
Closer Look: Gold
Among commodities, gold deserves special mention. Every society has valued gold, that shiny and malleable metal extracted from the earth in small quantities at great cost to life and limb. Many of these cultures never met each other, never had a chance to exchange cultures and values … but they still valued gold, almost instinctively. Across time, anywhere in the world if you had gold, you had money. To some monetary experts, it is the only ‘real’ currency.
Gold, and to an extent silver and platinum, are commodities that seldom lose value. There was a period during the COVID-19 crisis where oil was worth negative money, meaning you had to pay people to take oil off your hands. So, few people were driving and flying that the demand was extremely low. The price of the barrel itself was less than the cost to transport, insure, and store it. Hence, the negative price.
This is expected never to happen to gold. It is the rare commodity that, even if its value recedes, will potentially never drop to zero. It will always be worth something, and when economies collapse, it is often the only thing still worth something, besides food, shelter, and weapons.
The value of gold can be tied to three “polarities” — three polar opposite conditions that push the value of gold either up or down:
- Inflation and Deflation. In times of currency inflation, gold becomes more valuable, because its intrinsic worth does not change even as the value of paper money decreases. Conversely, in times of currency deflation, gold becomes less valuable.
- Greed and Fear. In times of great greed, gold becomes less valuable as investors chase higher-margin vehicles. In times of great fear, gold becomes more valuable as investors flee to a currency that has stood the test of time.
- Supply and Demand. When the gold supply is scarce, it becomes more valuable because there is less of it to go around. If mines become productive and flood the market with plentiful supply, gold becomes less valuable.
Closer Look: Oil
Oil is another notable commodity, steeped in geopolitics and international intrigue. Many of the factors that affect the price of gold spill over to oil. Oil traders and speculators attempt to assess which oil-producing nations will form powerful alliances or gnash their teeth at each other; what weather patterns will increase the demand for heating oil; what carbon-neutralizing regulations might push the energy market toward more green technologies.
For all of its importance, however, oil is perhaps most notable for being the commodity whose value is most subject to manipulation. The price of oil is heavily influenced by OPEC, a union of 13 oil-producing nations that exert a great deal of influence on the global supply of oil. More so than a foreign war or a sudden discovery of an ocean of oil in the Dakotas, the power of OPEC puts the value of oil in the hands not of market forces, but of a shockingly small group of people.
By understanding what commodities are, the different trading options, and the different market forces that influence them, informed Traders can incorporate commodity trading into a sound investment strategy.
This can take the form of either audacious but educated short-term positions that bet big on explosive gains. Or it can take the form of a diversified portfolio, the gaps filled with hedges against downturns, creating a bulwark of long-term growth and prosperity.