Commodity trading first appeared in Sumer (Iraq nowadays) far back in 4500 BCE and has spread much since then. Ancient civilizations traded a wide range of commodities: spices, food, oils, textiles, and many more. Ability to manage commodity production and trading system has always defined the might of empires, confirming a certain level of economic development.
The global commodities market really kicked off with the set up of Chicago Board of Trade in 1848. Now it's one of the most popular types of markets to trade on and everyone is affected by the commodity market developments one way or another. Drivers may feel the impact of the raised crude oil prices which affected the gas prices accordingly, and your lunch menu can lack some ingredients because prices for vegetables significantly increased, as a result of a recent draught and supply problems.
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Let's explore, what commodities are and what types of commodities people trade. A commodity is simply a basic good or raw material used in commerce.
It is interchangeable with other commodities of the same type and it is standardised. That means two equivalent units of the commodity usually have more or less the same quality and price anywhere in the world (excluding those influenced by local factors such as the cost of transportation and taxes). For example, 24 K Gold is of the same quality no matter where in the world it was produced.
Generally speaking, commodities are either extracted, grown or produced. Most traders and investors stick to the most traded commodities or the most liquid ones within the financial markets. There is a small selection from 4 main types of commodities traded on the market:
Precious metals like gold have historically been valued as reliable and were used as a hedge against high inflation in periods of currency devaluation.
Energy commodities production is tied closely with global economic development. Their price formation vastly depends on the actions of the major market participants and ever-changing energy demand. The oil market involves public and government-backed drilling companies, speculators, service companies like British Petroleum and Shell, airlines and other active buyers and sellers of oil.
Agricultural products are extremely volatile and form a very active market. They are sensitive to seasonal weather conditions and natural disasters. Moreover, population growth combined with the limited agricultural supply can cause a higher demand and price growth for this type of commodity.
Livestock and meat are less popular in trading than others. According to the Chicago Mercantile Exchange, the total trading volume of Feeder Cattle for November 2018 was just 1,365. This number represents how many contracts, for the right to buy or sell feeder cattle, have been bought and sold. These numbers are not huge because the Feeder Cattle market may only involve the farmer and the distribution company of the stock and it doesn't produce much trading activity.
After revising the list of the most popular commodities traded worldwide, let's find out, how to invest in commodities and why trading CFDs on commodities?
Why commodity trading requires the counterparty or intermediary? Can't you just buy the commodities directly from the source, re-sell them to a buyer and pocket the difference in profit? Well, at this point you are going to meet the following challenges: finding the right producer, storage for the purchased goods since commodities are physical products, a transportation company, an insurance company, and a buyer at last.
Unless you are buying gold, which is relatively easy to keep in a safe-deposit box, most of the other commodities are rather difficult to store. Just imagine, sugar is only sold in quantities of 112.000 pounds. Where could you store that amount of sugar, protecting it from rodents and humidity?
Sounds problematic, isn't it? Also, many issues that may affect the price of sugar within a short period of time, make it very volatile. While you are transferring the sugar from the producer to your storage, the price may drop prominently. Thus, this method of trading commodities is a very risky business indeed. Are there any other ways to invest in commodities, avoiding such risks? Yes, there are. One of them is to trade commodities through a broker.
Brokers offer several opportunities to trade commodities. One of them is to trade futures. Futures are the contracts of the future delivery of a commodity traded on the stock exchange. These legal agreements validate the buy and sell of the particular commodity or asset at a predetermined price at a specified time in the future and require no physical delivery of the product. The prices of the futures are controlled by the stock exchange in this case.
In simple terms, a trader pays for the contract at the beginning of the purchase. If prices rise between the purchase date and the expiration date, the trader profits. If prices fall, the trader loses money.
Of course, this method of indirect trading implies many pitfalls, because different futures markets provide disparate delivery dates and sizes of purchases also differ. Besides, some of the futures contracts are quite voluminous and, consequently, very expensive. These factors encourage traders to choose CFDs, a very popular method to trade commodities.
Why trading CFDs? A CFD (contract for difference - a contract between the trader and the broker) allows a trader to speculate on the rise and fall of the commodity price without owning it. CFDs are supposed to be one of the most profitable trading instruments: they allow to gain high profit even with a small initial investment.
In essence, the main goal of the trader in trading CFDs is to define whether the difference between the opening price of a commodity and it's the closing price is positive or negative. In the same way, the trader can gain profit trading CFDs on indices or trading CFDs on shares.
How do CFDs work? When the contract expires, the two parties exchange the difference between the price of the commodity at the beginning of the contract and the price of the commodity at the contract end. If the trader predicts the outcome of a trade correctly, the seller pays the difference between the initial buy price and the new value of the asset. Inversely, if the trader gets the prediction wrong and the asset moves in the opposite direction, he is expected to pay the difference to the seller. An example of the successful CFDs trade can be seen below.
When you trade CFDs the process of entering and exiting the position doesn't present a challenge and this makes commodity trading via CFDs extremely popular. Furthermore, there are some other advantages of CFDs trading:
A good trader knows that the price of every commodity is permanently affected by many unique factors. Even the slightest risk of shortage or abundance of some goods may be the reason for a huge price swing. This section overviews the influence of the supply and demand on the price formation.
The supply stands on the influence of multiple factors: government interventions, weather conditions, economic events, etc. Do you remember the re-imposing economic sanctions on Iran on the 6th of August 2018? Iran's oil, which is the fourth largest reserve in the world, was off limits for purchase. As a result, less oil was delivered to the market, the demand didn't change, so speculators took advantage of the shortage and set the desired prices on the remaining oil. This example clearly illustrates that a shortage of supply always causes price increase or even price swings.
The chart below (Chart 1) illustrates such price swing. Here, as the result of the economic sanctions mentioned above, the oil price ascended the next day after the sanctions were imposed (August, 7th) and went up over 900 points (marked in yellow) before a significant drop.
Chart 1. Please Note: Past performance should not be used as the indicator of future results or future performance.
What factors influence the demand then? Changes in consumer habits and the economic climate are the major factors that have a great impact on demand. Today we can see how society's attitude to such products like sugar and tobacco, has changed from positive to negative, thus shrinking the demand for these products.
On the chart below (Chart 2), you can see the sugar price swings for an extended period (2007-2019).
Chart 2. Please Note: Past performance should not be used as the indicator of future results or future performance.
The chart above reflects declines in sugar prices in 2010. From September 2015 to September 2016, there was an upward move, caused by concerns over a global shortage associated with disrupted supply from the world's largest sugar producer in Brazil. Sugar became scarce and prices increased.
However, in this particular case, sugar became expensive, the demand shortened, and the sugar price started sliding down. Remember we've told you that making profits on the falling market is real? Well, those, who realize the benefits of the supply and demand could earn lots of money on this price drop trading CFDs. Other trading instruments like shares could not be used in such falling scenario, because fast descending sugar prices could cause restrictions on further shares trading or even the stock exchange blackout period. Fortunately, CFDs trading is not restricted in such cases, which allows traders to make significant profits on huge ups and downs of the market.
It is important to mention that such commodities like sugar are not very popular for trading and the example above was just given in order to illustrate the opportunity window for trading CFDs in both rising and falling directions of the market. To fill the needs of its clients, MTrading provides many popular trading instruments.
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This material does not contain and should not be construed as containing investment advice, investment recommendations, an offer of or solicitation for any transactions in financial instruments. Before making any investment decisions, you should seek advice from independent financial advisors to ensure you understand the risks.