Best Brokers for Commodities Trading
As the essential components behind just about every other product imaginable, commodities are vital to modern economies. Find out how these volatile yet invaluable natural resources fit into the wider trading world.
WHAT IS A COMMODITY?
A commodity is a natural resource that can be processed and sold. Commodities that are tracked in the financial markets include agricultural goods, metals, energies and minerals, among others.
Commodities are the essential components of other manufactured goods – the building blocks for both industrial and domestic products and foodstuffs. They are shipped around the world to meet demand, because not all countries are capable of producing every commodity they need.
The production and consumption of commodities depends on factors such as climate, season and resources – both natural and man-made. Demand is also influenced by a complex interaction between economic factors and consumer habits.
Because of this, commodity prices have the potential to fluctuate greatly. Commodities are generally traded in very large quantities, either on the cash market or, more frequently, on the futures exchange.
Commodities can be grouped according to the similar characteristics they share. Below are some general terms used to classify them:
WHAT ARE SOFT COMMODITIES?
These are typically grown, rather than mined or extracted. Softs tend to be very volatile in the short term, as they’re susceptible to spoilage which can suddenly and dramatically rock prices. Producers tend to be heavily involved in the softs market, as they’re often keen to lock in prices for their produce. Alongside the natural growing cycle of these commodities, this creates seasonal fluctuations in prices.
Examples include: Corn, wheat, rice, cocoa beans, sugar, orange juice, cattle.
WHAT ARE HARD COMMODITIES?
These are typically mined from the ground, or taken from other natural resources. The initial commodity may also be refined into something else, for example oil is refined into gasoline.
Some agricultural products, such as cotton, are also considered hard commodities, as they don’t rot quickly and they are industrial materials rather than foodstuffs. Hard commodities are easier to handle than softs, and are more easily integrated into the industrial process. This makes them a popular choice for investors; for example trillions of dollars’ worth of oil futures are traded each year.
Examples include: Oil, natural gas, cotton, aluminium, copper, silver, gold, lead.
WHAT ARE EMERGING COMMODITIES?
These are commodities that some investors expect will be booming markets in the next few years, but are not currently available to trade as commodity futures. The only way to trade these products is by buying stock in companies that operate in these fields.
Examples include: Water and water rights, ethanol.
Major commodities tend to trade in very large quantities and it would be unrealistic for most traders to process them. Instead, and especially because of their volatile nature, commodities are often used for speculation on their prices.
They trade on the commodities market, which is made up of a number of international commodity exchanges. In the commodity market, as opposed to the stock market, everything expires – this is because the commodity will eventually need to be delivered to its final owner.
Futures contracts, such as CFDs, provide a number of benefits that entice both buyers and sellers.
Leverage: Futures trade on margin, meaning that investors only have to put up a fraction of the total value in order to trade.
Liquidity:Because there are normally speculators willing to take on the other side of a given trade, futures contracts are generally fairly liquid. This does vary between individual commodities, however.
Commission Costs: Fees are generally lower to buy or sell one futures contract than to buy or sell the underlying commodity.
Ability to go short: You can sell futures contracts just as easily as buy them, so you can profit no matter which direction the price is heading.
WHO TRADES COMMODITIES?
There are generally four schools of trader who use commodities.
HEDGERS: investors often buy or sell commodities to help manage their risk. In a balanced portfolio, commodities provide a hedge against downward movements in other securities, as they tend to move in the opposite direction, or an unconnected direction, to certain stocks and bonds.
SPECULATORS: investors with a particular opinion on a particular commodity are willing to take on the associated risk in the hope of turning a profit.
PRODUCERS: people that grow and harvest commodities may want to enter into a futures contract on them in order to offset the risk of future price movements.
BROKERS: these are firms or individuals who carry out the order to buy or sell commodity contracts on behalf of their clients.
WHAT DRIVES COMMODITY MARKETS?
The commodity markets help to ensure some stability in price, especially through futures contracts. These allow suppliers to lock in the price they’ll receive for their produce at a future date; so the price is also fixed for the buyer.
The commodity prices quoted in the market, therefore, are often the futures price for each commodity; the fixed price at which a commodity will be traded at a specified point in time. Below are some key factors affecting commodity prices:
Supply and Demand: Let’s take oil as an example. If the supply of oil becomes more plentiful but demand remains level, the price of each barrel will decrease. If more people are using oil but producers don’t have the capacity to match this demand, the price of each barrel will increase.
Economic and Political Factors: Although commodities are normally traded on futures prices, economic events that happen now will affect the levels of these prices. For example, political unrest in the Middle East often causes the futures price of oil to fluctuate due to uncertainties on the supply side.
Weather: Agricultural commodities such as wheat or coffee will be heavily influenced by the weather, as it controls the harvest. A poor harvest will result in low supply, causing rising prices.
The dollar: Commodities are normally priced in dollars, and generally move inversely to that currency. A rising dollar is anti-inflationary, so it applies downward pressure on commodity prices. Similarly, a falling dollar will usually apply upward pressure on commodity prices.
Inflation and commodity prices
Commodities can be used as a natural hedge against inflation. If rapid inflation seems imminent, you may see commodity prices rising very quickly – they may even provide the first sign of inflation. This is because people will be moving money out of investments that don’t offer a hedge against inflation and into the commodity markets, to protect their assets.
WHAT IS A COMMODITY PRICE INDEX?
A commodity price index is a weighted average of commodity prices, grouped to represent a broad class of asset or a more specific subset. Broadly speaking, the constituents of a commodity price index can be grouped as follows: energy, metals (base metals, precious metals), agriculture (grains, soft commodities, livestock). Depending on the index, the prices of the constituent commodities may be spot or futures prices. Some examples of commodity indices include:
THE CONTINUOUS COMMODITY INDEX (CCI) comprises 17 commodity futures which are continuously rebalanced to maintain an equal balance of 5.88% each. This gives a benchmark of performance for commodities as an investment.
THE S&P GSCI (FORMERLY THE GOLDMAN SACHS COMMODITY INDEX) acts as a benchmark for investment in the commodity markets, and its constituents are drawn from all commodity sectors. This index is available to those invested in the Chicago Mercantile Exchange.
THE MERRILL LYNCH COMMODITY INDEX (MLCX) contains commodities that are selected by liquidity and then weighted according to the importance of each commodity in the global economy.
WHAT ARE THE DIFFERENT WAYS TO TRADE Commodities?
CFD TRADING ON COMMODITIES
By trading commodity Contracts for Difference (CFDs), you can gain exposure to the markets at a fraction of the cost of owning a quantity of the underlying commodities. When trading CFDs the idea is that you agree to exchange the difference in value of a particular commodity between the time you open your position and the time you close it. This means that you can trade no matter which direction you think the commodity is going to move. To find out more, please visit our CFD trading module.
CFDs are a leveraged product and can result in losses that exceed your initial deposit.
SPREAD BETTING (UK ONLY)
Financial spread betting offers a tax-free* way to make the most of volatility in commodity markets. By speculating on the direction in which you think a commodity will move, you can profit from both rising and falling prices. As a leveraged product, you can achieve maximum exposure without having to put up the full value of your position. You’ll find spread bets available for all the major commodity markets – and with many markets open 24 hours a day, you can react to world events as they happen.
Spread betting is a leveraged product and can result in losses that exceed your initial deposit. *Tax laws are subject to change and depend on individual circumstances. Tax law may differ in a jurisdiction other than the UK.
Futures contracts enable two parties to exchange the difference in value of a commodity – or other asset – at a specified future date, for a price agreed today. Investors use commodity futures either as a hedging tool, or to speculate on the price movement of the underlying asset. Futures contracts dictate the quality and quantity of the underlying asset; these measures are standardised so that they can be traded on a futures exchange. Some futures contracts may call for physical delivery of the asset, while others are settled in cash.