Advancements in technology have radically changed the investment world in recent years. It’s now possible to trade assets using your smartphone.
While stocks typically get most of the attention, commodities can be a good way to diversify a portfolio. Understanding the types of products available and ways to trade them will expand your horizons.
Types of Commodities Available for Trading
Commodities are the building blocks utilized to create more complex goods or services. They are usually grown or extracted but in some cases — like RBOB gasoline — they are produced from other commodities.
Another critical aspect of commodities is that they are fungible. This means that one unit of a commodity is interchangeable with any other. So one bushel of corn is equivalent to another.
Commodities are generally subdivided into three categories:
- Metals: aluminum, copper, gold, platinum, palladium, silver, tin
- Energy: Brent crude oil, heating oil, natural gas, RBOB gasoline, Uranium, WTI crude oil
- Agriculture: Corn, cotton, wheat, orange juice, feeder cattle, lean hogs, lumber.
Metals are sometimes subdivided into precious metals (eg, gold) and industrial metals (eg, copper). Agriculture is also subdivided into crops (eg, wheat) and livestock (eg, cattle). And some commodities cross-over, like ethanol, which is an energy commodity made from an agricultural commodity.
Understanding the Different Ways to Trade Commodities
There are many ways to trade commodities. The most obvious is a direct purchase. For example, people can purchase gold bullion, which is delivered to them. But for most commodities (and usually even for gold), there are other trading vehicles like contracts for difference (CFDs), futures contracts, options, and exchange-traded funds (ETFs).
With futures and options, you can potentially take physical delivery. But traders normally sell these contracts before their expiration dates. Below is a breakdown of the more popular trading methods available to commodities traders.
CFDs are contracts priced relatively close to the current spot value of the underlying commodity. When you think a commodity will go up in value, you trade on the buy-side. If you think it’s going down, you can go short by trading on the sell-side.
One of the aspects of trading commodity CFDs you may find attractive is the leverage they provide. You can invest a relatively small amount of funds to generate significantly large gains. However, while this is an attractive way to increase profits, it also increases the risk of losing money.
For example, you may be able to use 10 percent or $100 of your capital to purchase $1,000 worth of CFDs when a commodity is valued at $1.00. If the value goes to $1.50 and you close your position, you’ll receive $1500 or a $500 profit. Alternatively, if the commodity value goes down to $0.50, you will lose $500 — five times as much as your initial trade.
Commodity futures contracts are agreements to buy or sell an amount of a specific commodity at a future date. Institutional or commercial commodities consumers or producers may take actual delivery of the commodity. As a trader, you can liquidate your contract before the expiration date. Doing so allows you to speculate on the value of the commodity you are trading.
Similar to trading CFDs, futures contracts also provide you with the ability to use leverage. Futures contract prices can tick up or down quickly, especially if related news or reports are released. Timing is critical.
Options are a special kind of contract that allows you the right to buy a commodity at a later set date. If the price of the commodity has gone up, you exercise the option. If the price of the commodity has gone down, you don’t exercise the option. The catch is that you must pay a premium for the option, which you lose regardless of whether you exercise the option or not.
Using a commodity ETF provides you with an investment vehicle exposed to one or more commodities. ETFs can invest in physical commodities, futures, commodity-based stocks, and other equities. For example, the value of a precious metals ETF might be derived by holding shares in major gold mining companies. When the value of these shares rises or falls, it’s reflected in the ETF value.
Trading ETFs can be less risky than other methods. This can limit your gains but doesn’t present the level of risk associated with CFDs and futures. But if you want to diversify your portfolio with commodities, ETFs can be a good choice.
Before you start trading commodities, you will need to find a broker. We highly recommend getting one that offers a demo trading account. Taking this action allows you to gain exposure without risking your money.
It’s also essential to follow a commodities trading strategy to help mitigate your risk. Broadly speaking, there are two approaches: fundamental and technical analysis. Fundamental analysis focuses on production levels and macroeconomic data. Technical analysis uses charting and technical indicators. Both are very useful and they can be used together.
Your next step might include becoming familiar with the price action of one or two commodities and the news and reports associated with them. This can give you a better idea about their price fluctuations and the methods you’d like to use to trade them.
Commodity trading is interesting on its own and as part of a larger trading strategy. But keep in mind that it is risky. Most traders lose money. You will almost certainly need a lot of experience, study and luck before you can succeed.