As an investor, you are likely to always be on the lookout for trading strategies that will help you maximize your growth potential. Are you aware of commodity prices, a form of trading that existed even before the stock market?
Commodities trading might vary a bit from general mutual funds as it has come a long way since its inception. In earlier days precious metals and raw materials were being exchanged between different geographies. Even farmers in the olden days engaged in what is called “futures contracts” where they could set up a price that would help in delivering goods in the future. Futures contract was seen as an effective way of doing business in those days.
But commodity markets are vastly different in today's time. This type of trading mostly takes place in a commodity-specific exchange market. Just like all forms of investment commodity trading too comes with its own set of risks. This is mostly because commodities are traded on futures contracts, making them unique unlike some other stocks or mutual funds.
Through this article, you will get to know the functioning of commodity trading, how it operates and what are the risks involved in this form of trading.
What is a commodity?
Basic items of consumption like food, sources of energy, metals, basically anything that can serve as a purpose of trade between buyers and producers qualify as commodities. Commodities are often interchangeable, which means that their quality remains intact when they are exchanged between one producer to another.
These days with the advancement of technology internet bandwidth, foreign currencies, indexes, cell phone minutes, and several other financial instruments are classified as commodities. Traditionally commodities would mostly appear in the form of metals (gold, silver, platinum and copper), petroleum products (oil/natural gas), meat (beef/pork), and agricultural products like wheat, rice, cocoa, and coffee, cotton and sugar.
Commodities Trading: History
As mentioned before, commodity trading comes a long way. In the olden days, there were many empires that were born to create trading platforms that could be centralized and would encourage commodity trading.
These days, commodities are being traded all across the globe. Usually, in this form of exchange there is a physical area that serves as a commodity trading platform, and alongside this, there is a legal entity that is being created – one that will lay the rules for contacts and investments.
Risks involved while investing in commodity
Commodities are usually traded on futures contracts, unlike the stock market. Futures contracts are arrangements between traders who intend to purchase or sell a particular commodity at a specific price at a given time sometime in the future and thus the name.
In this case, both the buyer and seller can earn money within the right conditions. When the value of a particular commodity goes up, the buyer gets to make money since he got it at an agreed-upon price, which may be lower than the market conditions.
But you must know that commodity prices are really volatile. Sometimes they change weekly and oftentimes even daily. So, it can be safely predicted that one party among the buyer and seller is likely to lose money in the transaction.
Investment in commodities looks promising but it is still a risk
You must know that most people like to trade in volumes due to its attractive returns, which levarges this form of investment, but contemporarily there has been a lot of volatility in commodities price movements. There have been immense fluctuations in prices majorly due to a mismatch between demand and supply, problems in the global market conditions and high liquidity.
It's your hard-earned money and in order to see the maximum returns, you might as well invest it somewhere that helps you fetch good returns. That being said, we are enlisting the most popular categories that are traded in the commodity market and how can they help you as an investor.
- Industrial metals
These are commodities like aluminium, copper, nickel, zinc and steel. Usually, industrial metals are affected by macro-economic factors in the world like border tensions in Ukraine, financial setbacks, etc. As an investor, you can try investing in industrial commodities when you are taking a speculative stand either via a commodities broker or by investing in commodities-based stocks.
Even though there is no hard and fast rule that there is a correlation between commodity prices and commodities stock price movement, however, in case all things are equal, commodity prices can be the most important tenet in determining the pricing of stocks that are commodity-based.
- Precious metals
Gold, silver, and platinum come in the form of precious metals. They always are trading high and investors have been investing tremendously in precious metals. Most investors that are based globally have been investing in precious metals to fight against economic stress or any kind of uncertainty.
In the last few years, there have been many investors seeing attractive returns in this segment. As an investor, you can also try investing in smaller quantities and at frequent intervals. You may try investing via ETFs (Exchange-traded funds).
- Agricultural commodities
Commodities like sugar, chilli, pepper, soya and oil fall under this category. Here, the fluctuation in prices are dependent on factors like production and supply and government policies.
If you are thinking of investing here, then you must be knowledgeable and have a clear understanding of the local markets and how they work. So, agricultural commodities might be a difficult investment portfolio for small investors.
- Energy commodities
Portfolio diversification is interesting to note as an investor and asset allocation could get easy too. Energy commodities usually include direct investment and come in the form of crude oil and natural gas.
Their price movements are determined by the demand in larger nations like the US, China and India. Due to a lot of turbulence, and rising prices in the global market, there has been a lot of volatility in the prices of energy. If you like to take high risks then you can look for investment opportunities in this sector.
How can stocks be used to invest in commodities?
If as an investor you are interested in entering into the commodity market, you may also consider investing in stocks that are associated with commodities. You would see that many investors investing in the oil industry have been investors in natural resources.
In case you favor gold then you may try buying stocks in smelting, reprocessing or any mining company that engages in a particular commodity. Usually, people think of the stock market as one that is not prone to too much volatility, and also it's much easier and safer.
How can ETFs and Notes be used to invest in commodities
Mostly exchange-traded funds (ETFs) and exchange-traded notes (ETNs) help traders to gain profit from fluctuations in commodity prices, without committing directly to the futures markets.
Most investors favor this fund by buying real estate assets. For secured entities, ETNs help in simulating the price fluctuations in several commodities and other indexes. They are issued on the behalf of the issuer.
How should you invest?
If you are thinking of investing in commodities, then you can make a direct investment by buying your own products and by investing in mutual funds. This might require you to gain exposure by purchasing investment products that are based on the stocks of companies that deal with certain types of commodities.
Also, you can use ETFs or Future Contracts for investment purposes. They may be trading ETFs/commodities to commodities indexes or commodity contracts. The trick is to hire a trader who will help manage your accounts, otherwise, it can prove challenging.
Is commodity worth the risk?
Through this article, we have tried to give you a download of investing in commodities and what are the risks involved in there. Sure, at any given point we would want you to make informed decisions about your investment.
While in the previous paragraphs we did try exaggerating the risks involved in this form of investment, we would again like to highlight that commodity prices usually have a tendency to get higher when the supply and demand determine the price. And, when you lose the money you lose lots of it. In the case of traditional mutual funds, there is an added layer of security, and commodity funds can offer limited exposure in certain sectors.
Investing isn't a bad idea but opening a commodity portfolio or trading future contracts should not be your primary strategy.