Any product gathered or created for human usage, serving their basic needs from eating and drinking, is a commodity. It is usually produced in bulk and differentiated by categories.
Like any tradable instrument, products can be traded in the financial markets, and there are some popular exchange markets where traders buy and sell different types of commodities and speculate on their prices.
The London Metal Exchange (LME), The New York Mercantile Exchange (NYMEX) and The Chicago Mercantile Exchange (CME) are famous trading markets for commodities, where the latter is estimated to manage three billion contracts of goods and products.
Commodity As a Trading Instrument
The global market allows participants to trade commodities and raw materials in dedicated markets. These are considered tradable assets, and they have two types.
- Hard commodities: These are natural products that need to be extracted or mined, like gold, silver, or oil.
- Soft commodities: These are agricultural materials or livestock that are harvested or gathered, like coffee, corn, and meat.
Manufacturers and users of these assets can participate in secondary markets where these goods are traded. Other market participants include speculators and investors who speculate on the prices of these goods.
However, trading these assets requires proper understanding and technical analysis of the nature of each product and its impact on other markets.
For example, precious metals are known to be a good hedge in times of inflation. Also, some stock traders prefer to diversify their portfolio with commodity futures because the prices can move in the opposite direction to stocks, which makes commodity trading a reliable option.
Commodity trading used to be exclusive for professional traders because it needed time, capital, and knowledge. However, today, more traders are participating in this market.
The development of technology added more products and goods to the marketplace, like tobacco and orange juice, and included more financial instruments and terms like CFDs and indices.
Some market experts suggest that commodities should be included in the trading portfolio because of their nature. Commodities usually move independently from other financial assets, which makes a solid inflation hedge.
Can You Trade Commodities Physically?
To trade commodities physically, one needs to transport the products from one place to another, and it could be across the continents, even crossing seas and oceans carrying tons of commodities, which is understandably difficult.
Additionally, foreign policies affect the trade policy and the transportation of goods between countries. Before trade agreements and the World Trade Organization were founded, disputes used to occur between countries, and some products were refused at the borders or extreme tariffs on entry, so the receiver would not get what they were expecting.
The oil crisis of 1973-74 is a clear example of when Arab countries stopped supplying oil to the United States. If a trader had bought crude oil, getting it physically inside the States would have been impossible.
Exchange rates and transportation shortages are issues that face trading today. However, the WTO helped overcome most of the trading problems, setting the ground for traders and countries to transport goods between countries, with rights and obligations for every party involved in the treaty.
Ideally, producers sell their goods to buyers (manufacturers or consumers) in exchange for money or to traders who want to trade these commodities further.
Over time, more trading tactics appeared in this market, giving flexibility in the marketplace. Future contracts are examples where the buyers and sellers enter into an agreement to trade the commodity at a specific price and date. This option helps mitigate massive price volatility, helps budget planning, and stabilises the trading flow.
Factors Affecting Commodity Prices
Like other financial instruments, commodities are affected by the rules of supply and demand. For example, in developing economies, the demand for oil and energy products is more likely to increase.
Other factors affecting commodity prices include natural catastrophes, wars, and economic uncertainty. All these affect the supply and demand and, eventually, the price of commodities.
When inflation rates go up, commodity prices usually go up, and traders start buying as their prices increase, especially in times of high inflation. During inflation, the prices of goods and services increase, and while commodities are still required to manufacture and provide goods and services, the prices for some commodities also tend to rise.
Thus, investors buy commodities as an inflation hedge to offset the decreasing purchasing power.
Other market participants are speculators who are not looking to use or consume commodities and are only interested in making profits. Therefore, these traders will speculate on the prices of commodities and use derivatives to buy or sell in the exchange market without physically owning the product.
Where Can You Trade Commodities?
Commodity traders buy and sell futures contracts in the exchange markets, where each market puts its standards for the quality and quantity of the commodity denominated in the contract. For example, one exchange market may set its criteria for a wheat contract to 5,000 bushels.
Generally, there are two types of traders in the commodity market:
- Buyers and sellers are looking to receive the commodity once the futures contract expires physically.
- Market speculators are there to make money, using derivatives to place buy/sell orders and profit when the commodity price increases or decreases, without really owning the product.
Conclusion
Commodities are treated like any financial assets and can be traded in exchange markets. Whether someone is looking to own a commodity or only to make money from trading, the value of a commodity is affected by the rules of demand and supply and by uncontrollable factors.
However, these are assets that provide security when inflation increases, and they provide a hedge against unpredictable volatility.
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