The main reason is due to the price volatility of commodities. Traders can make good profits (if they take the right positions), since the prices of commodities can experience large fluctuations within a short period due to the various risks explained below. If leveraged trading is used, the profit margin of a commodities investor can be increased even further.
What is a Commodity & What are the Key Types of Commodities
A commodity is in essence a primary agricultural product or a raw material that can be sold or bought.
Commodities that drive our modern global economy are the ones which are most frequently traded. The Main Categories of commodities in commodity trading include:-
- Agricultural commodities (eg. sugar, rice, corn, cotton, wheat, cocoa, soybeans and coffee)
- Metals commodities (eg. copper, silver, gold and platinum)
- Energy commodities (eg. gasoline, heating oil, natural gas and crude oil)
- Livestock and Meat commodities (eg. live cattle, feeder cattle, lean hogs and pork bellies)
Key Risks Involved in Commodity Trading
As you are aware, all investment instruments in the financial world carry risks (and also, the opportunity for rewards). In the case of commodities, you need to be aware and familiar with these 4 key risks:-
#1 Risk: Weather & Climate
Weather and climate changes can affect crop yields significantly. For example, the prices of soft commodities which are agricultural in nature (eg. coffee, cocoa, wheat, rice) will increase if bad weather conditions results in poor harvests that limits the commodity’s supply. Similarly, good climate and bumper crops may cause prices of commodities to soften.
#2 Risk: Supply & Demand
Economics principles tells us that when supply exceeds demand, prices of commodities will fall. Likewise, where demand exceeds supply, the prices of commodities will rise. An unexpected huge increase in supply of commodities into the market, or an unexpected demand for commodities (eg. due to major infrastructure and urbanization efforts of countries increasing demand for metals), will therefore also cause a major swing in the price of the affected commodities.
#3 Risk: Exchange Rate
Generally speaking, commodities are priced in US Dollar (USD) terms in the global market. As such, any movement of the USD for and against our local currency (i.e. Singapore Dollar (SGD)) will materially affect the prices of commodities.
#4 Risk: Political Development
Political instability or unexpected developments/policies in any large producer of commodities (eg. affecting the supply of rice in Thailand or crude oil in Saudi Arabia), will cause a major increase in commodity prices due to the sudden shortage.
How to Invest in Commodities
The 4 common ways the world trades in commodities are as follows:-
- Buying the commodities directly or physically
- Buying shares in commodity companies
- Buying them indirectly through investment trusts or funds
- Trading futures contracts
Ways You can Trade Commodities in the Financial Markets
In the financial markets however, investors trade commodities based on (i) Spot Price or (ii) Futures Contracts. They profit or make losses based on price movements (for or against) the positions they trade.
(i) Spot Price
This means the price of the commodity which you pay “on-the-spot”. Your company will pay the “spot price” (i.e. the existing price in the market for the commodity) if it wants to purchase a kilogram of gold today.
A contract for difference (CFD) allows you to trade commodities on the current spot price (eg. Spot Silver or Spot Gold). You can hold your trade positions for however long you wish, since spot positions do not have a date of expiry.
(ii) Futures Contracts
This refers to a contract for purchase of a commodity in the future. So the buyer and seller will come together and agree on the price for the future delivery of the relevant commodity.
Futures Contracts, unlike Spot Positions, will expire in future at the specified date. Whether you make or lose will depend on the future price of the futures contract, relative to the current spot price. Due to the high volumes traded globally, Futures Contracts are traded in a standardized form via specialized commodity exchanges which process the trades and mark the contracts to market daily.