Commodity Trading: An Overview

Introduction

 

Trading is the process of buying and selling of goods and services. Generally, stocks and bonds are associated with trading. However, there are many other financial assets that can be traded either on the stock exchanges or over the counter.

 

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This blog seeks to explore the world of commodity trading. Commodities form an important aspect of most of our lives, examples of commodities are wheat, gold and silver. 

 

Now, commodity trading or investing provides a trader or investor an opportunity to diversify their portfolio beyond the traditional financial securities which include stocks and bonds. Alternatively, a market participant more familiar with commodities will tend to allocate much more of his/ her portfolio on commodities as compared to other types of securities.

 

This blog discusses the different types of commodities, role of commodity exchanges and the various methods of trading in commodities in an effort to understand the various aspects of commodity trading in order to develop an edge provided by diversification. 

 

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Different Types of Commodities

 

Broadly, commodities can be classified into four categories: metal, energy, livestock and meat, and agriculture.

 

1. Metals: 

 

Metals can be further sub-classified into base metals and precious metals.

 

1. Base metals: Base metals are common metals that tarnish, oxidise, or corrode relatively quickly when exposed to air or moisture. They are easily distinguishable from precious metals and form as important inputs in commercial and industrial applications. Lead, copper, nickel, aluminum, zinc, etc. fall under this category.

2. Precious metals: Precious metals are rare metals, bullion in nature. Such metals have a high economic value attributed to a variety of factors including their scarcity, application in industrial processes and historical role as a store of value. The most popular precious metals include gold, silver and platinum. 

 

During volatile market periods and bear markets, a lot of the market participants tend to rotate their capital allocation to metals as they form reliable bets with conveyable value. 

 

Similarly, in periods of high inflation or currency devaluation, investors may prefer to seek refuge with metals which usually do not suffer such a fate. Therefore, metals may form a good hedge in uncertain markets.

 

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2. Energy: 

 

Just like metals, energy commodities form an integral part of most of the economic activity worldwide. Examples of energy commodities include crude oil, natural gas, gasoline and heating oil. 

 

Crude oil is used in transportation activities and production of plastics, natural gas is used for natural electricity generation and transportation, gasoline again is used for transportation and heating oil is used as a fuel for furnaces and boilers.

 

Similar to other commodities, when trading in energy commodities, a market participant needs to be aware of the various factors that affect the price of the particular commodity. 

 

Overall it is the change in the balance between supply and demand of a particular commodity that determines its price both  in the primary and secondary markets. 

 

A few of the factors that determine the price of energy commodities include shifts in production worldwide, advances in alternative energy sources, changes in government regulations, political uncertainties, etc. (From)

 

 

3. Livestock and meat:

 

Livestock refers to domesticated animals raised in an agricultural setting to produce labor (services) and commodities (goods) such as meat, eggs, milk, fur, leather and wool. Commonly traded livestock and meat commodities include lean hogs, pork bellies, live cattle and feeder cattle.

 

 

4. Agriculture: 

 

Major agriculture commodities include corn, soybeans, wheat, rice, cocoa, coffee, cotton and sugar. A few of the factors that determine agricultural commodities’ prices include weather conditions, energy commodity prices, population structure, alternate applications of such commodities, currency prices, etc. 

 

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The next section discusses the various ways in which the four broad types of commodities listed above can be bought and sold. 

 

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Methods of Trading in Commodities:

 

There are several ways of trading commodities with their own pros and cons. Below are listed a few of the common ways in which a market participant can keep commodities in his/ her portfolio:

 

1. Commodity Futures:

 

The most common and widely-used way to trade commodities is to buy and sell contracts on a futures exchange. Futures are a type of derivatives. Derivatives are financial instruments that are derived from other assets. In the case of commodities, commodity derivatives are derived on the value of the underlying commodity. 

 

Just like stock exchanges facilitate the transactions of stock futures, commodity exchanges (discussed in the next section) facilitate the transactions of commodity futures. 

 

Commodity futures form the best way to trade in commodities since they provide sufficient liquidity, margin and prevent the hassle of physically transacting in commodities.

 

 

2. Physical Commodity Purchases:

 

Commodity future traders seldom take delivery of the underlying commodity. They square-off their positions prior to the expiry and therefore, are not obligated to take delivery despite having fulfilled their speculative or hedging purpose behind the trade.

 

Another way of transacting in commodities is through physically purchasing them in the retail markets. Usually traders or investors make physical commodity purchases for precious metals like gold and silver in the form of bars, coins, jewellery, etc.

 

The primary disadvantage of physical commodity purchases is the high markup cost or the additional costs incurred by the investors over the spot price on the retail market.

 

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3. Commodities Stocks:

 

Another option of trading in commodities is to buy the stock of a company involved with a commodity. For example, an investor may buy the stock of a copper refining or drilling company in an attempt to bet on the prices of copper going up.

 

Such a method relies on the company profiting from the increase in the price of the underlying commodity since it is involved in the value chain of that commodity. The extent of the change in price of the commodity on the profitability of the company depends upon the extent of involvement of the company in the value chain of the commodity along with other factors.

 

It is important to note here that this method does not guarantee a positively correlated price change of the stock of a company with the underlying commodity since there are other factors at play as well.

 

 

4. Commodities ETFs, Mutual Funds and ETNs:

 

Commodity-based mutual funds, exchange-traded funds (ETFs), and exchange-traded notes (ETNs) are also available. These funds pool money from a large number of small investors to create a big portfolio that attempts to track the price of a commodity or a basket of commodities. The fund may purchase futures contracts to monitor the price, or it may invest in the stock of various commodity-exposed firms.

 

Such funds provide access to small investors who otherwise might not have access to sufficient funds to buy even a single futures contract of a commodity. Additionally such funds are low cost, highly liquid and provide tremendous diversification opportunities.

 

(Also Read: Mutual Funds in India: An Overview)

 

 

5. Commodity Pools and Managed Futures:

 

The last method of trading or investing in commodities is through commodity pools and managed futures which are private funds that can invest in commodities. 

 

Such funds are similar to mutual funds and ETF funds but employ more complex strategies for better returns and are not publicly traded. They usually charge a higher management fee as well.

 

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Commodity Exchanges 

 

As pointed out in the previous section, the most common method of trading in commodities is through commodity futures. Commodity exchanges facilitate the transaction of such futures and other such derivatives. 

 

Examples of a few commodity exchanges:

 

1. Chicago Board of Trade (CBOT): CBOT, founded in 1848 is the oldest futures and options trading exchange in the world. It is a subsidiary of the Chicago Mercantile Exchange (CME) and offers more than 50 different derivatives across various asset classes. 

 

2. New York Mercantile Exchange (NYMEX): NYMEX is the world’s largest physical commodity exchange. It is a subsidiary of the CME group as well. It operates Commodity Exchange, Inc. (COMEX), a leading metals exchange.

 

3. Shanghai Futures Exchange (SHFE): SHFE offers trading in a variety of metals and energy commodities. SHFE is a non-profit regulated by the China Securities Regulatory Commission.

 

4. Australian Securities Exchange (ASX): Australia’s primary securities exchange, ASX offers futures and options markets on agricultural, energy, and electricity commodities. ASX merged with the Sydney Futures Exchange in 2006.

 

5. European Energy Exchange (EEX): EEX is the leading energy exchange in central Europe and offers futures on energy, agriculture, metals, biomass, and environmental commodities. The EEX offers markets on emissions auctions and emissions secondary markets.

 

There are several other commodity exchanges worldwide including the Deutsche Borse AG of Germany, the Multi Commodity Exchange (MCX) of India, the Tokyo Commodity Exchange (TOCOM), etc. Almost all the major countries have a commodity exchange. 

 

(Related blog: 10 Largest Stock Exchanges in the World)

 

 

Conclusion

 

Just like trading in other asset classes, commodity trading requires some sort of analysis. The analysis could be fundamental, technical or both. Different types of traders and investors participate in different types of asset classes depending on a lot of factors determining their edge.

 

Commodity trading is as beautiful as equity trading or bond trading and opens upon a great domain for diversification for market participants worldwide.

 

Just like all stocks are not equally liquid, commodities also vary in liquidity with natural gas, crude oil, gold, silver, cotton, corn, wheat being the most traded commodities globally and crude oil and gold being the most favourite commodities among the traders and investors community.