What Are Commodities and How to Trade Them?

Commodities, in the context of financial markets, refer to basic physical goods that are standardized and interchangeable with other goods of the same type. These include natural resources or agricultural products such as oil, gold, corn, wheat, natural gas, and copper. Commodities are a crucial part of the global economy as they serve as raw materials for the production of more complex goods and services. In the financial markets, commodities can be traded through futures contracts, stocks, ETFs, options, and other financial instruments.

There are two main categories of commodities:

• Hard Commodities: These are natural resources that are mined or extracted, such as oil, natural gas, gold, and copper.

• Soft Commodities: These include agricultural products like corn, wheat, coffee, and cotton, which are typically grown and harvested.

In the United States, commodities are typically traded on specialized exchanges, such as the Chicago Mercantile Exchange (CME) and the New York Mercantile Exchange (NYMEX). The prices of these goods are influenced by supply and demand dynamics, geopolitical events, weather patterns, and broader economic trends.

Investors often turn to commodities as a means of diversification or as a hedge against inflation, as commodity prices tend to rise when inflation increases. Additionally, commodity prices can be more volatile than other asset classes like stocks or bonds, which presents both risks and opportunities for traders looking to capitalize on short-term price movements.

Commodities are generally categorized into two main groups: hard commodities and soft commodities. Each category covers specific types of raw materials and resources that are integral to the global economy.

Hard Commodities

Hard commodities are natural resources that are extracted or mined from the earth. These are typically non-renewable and are often seen as foundational to industrial activity. Key examples of hard commodities include:

Energy Commodities

• Crude Oil: One of the most traded commodities globally, crude oil is a key driver of the global economy, powering transportation, manufacturing, and more. Oil is traded primarily through futures contracts on exchanges like the NYMEX and the Intercontinental Exchange (ICE).

• Natural Gas: Another crucial energy commodity, natural gas is used for heating, electricity generation, and industrial processes. It is often traded as a futures contract and has high volatility due to fluctuating supply-demand factors.

Metals

• Gold: Valued both as a store of wealth and a hedge against inflation, gold is traded both as a commodity and an investment asset. It is also used in industries like electronics and jewelry.

• Silver: Another precious metal, silver is used both for investment and in various industrial applications, such as solar panels and electronics.

• Copper: An industrial metal essential for electrical wiring, construction, and manufacturing. Copper prices are often seen as a bellwether for economic health due to its widespread industrial use.

• Platinum and Palladium: Used primarily in automotive catalytic converters and electronics, these metals are also traded for investment purposes.

Soft Commodities

Soft commodities are agricultural products that are grown, harvested, or produced. These are typically renewable and influenced significantly by weather patterns, growing seasons, and demand from food and textile industries. Key examples of soft commodities include:

Grains and Oilseeds

• Corn: A major crop in the U.S., corn is used for food, animal feed, and ethanol production. Corn futures are among the most actively traded agricultural products.

• Wheat: A staple food commodity, wheat is produced globally and traded on exchanges like the Chicago Board of Trade (CBOT).

• Soybeans: Used for food products, animal feed, and industrial applications like biodiesel, soybeans are another important agricultural commodity.

Additional Soft Commodities

• Coffee: One of the most traded soft commodities, driven by global consumption.

• Sugar: Used in food production and increasingly in biofuel production, sugar prices are sensitive to both weather conditions and government policies.

• Cotton: A vital commodity in the textile industry, cotton futures are influenced by both global demand for clothing and agriculture factors like weather.

• Cocoa: The primary ingredient in chocolate, cocoa prices are highly volatile due to weather and geopolitical issues in key producing regions like West Africa.

Commodities - whether they are agricultural products like corn or natural resources like oil - serve as fundamental building blocks of the global economy. As a result, fluctuations in commodity prices can be driven by various economic, geopolitical, and environmental factors. Understanding these key drivers is essential for traders and investors seeking to navigate the commodities market effectively.

At the most basic level, supply and demand dictate commodity prices. When supply is constrained due to production issues, natural disasters, or geopolitical tensions, prices tend to rise. Conversely, when supply exceeds demand, prices typically fall. Demand-side influences are equally important—rising industrial activity or consumption can boost demand for raw materials, which then puts upward pressure on prices. For example, the growing demand for electric vehicles has increased the need for metals like copper and lithium, driving prices higher.

Geopolitical events also play a significant role in commodity price fluctuations, particularly for energy commodities like oil and natural gas. Conflicts, trade sanctions, or political instability in key producing regions can disrupt supply chains and drive prices higher. The global oil market, for instance, is highly sensitive to geopolitical risks, with production cuts by major players like OPEC or unrest in oil-rich regions often resulting in significant price swings. For example, the oil price surge during the Gulf War in 1990-1991 was a direct result of supply fears.

In addition to these direct influences, macroeconomic trends like inflation, interest rates, and currency fluctuations can have a profound impact on commodity prices. Commodities are often viewed as a hedge against inflation, as their prices tend to rise when the purchasing power of currencies falls. Additionally, because most commodities are priced in U.S. dollars, fluctuations in the value of the dollar can influence global demand. When the dollar strengthens, commodities become more expensive for foreign buyers, potentially reducing demand and leading to lower prices. Conversely, a weaker dollar can boost demand and push prices higher.

Another critical factor is speculative activity in the commodities markets. Traders and investors often take positions in commodity futures, betting on price movements driven by factors like weather forecasts, economic reports, or even anticipated geopolitical events. While speculation can sometimes drive prices away from fundamentals, it also adds liquidity to the market, which can help in price discovery. However, when speculation reaches extreme levels, it can lead to significant volatility, with prices swinging more dramatically than supply-demand dynamics alone would dictate.

Taking specific examples, oil is one of the most volatile commodities, with prices highly sensitive to geopolitical risks, changes in production quotas, and fluctuations in global demand. For instance, during the COVID-19 pandemic, oil prices plunged as demand collapsed due to widespread lockdowns and reduced travel. However, when production cuts by OPEC and other oil-producing nations were announced, prices began to stabilize and eventually recover.

On the other hand, gold behaves differently. Often viewed as a "safe haven" asset, gold prices tend to rise during times of economic uncertainty or when inflation fears loom. Investors flock to gold as a store of value when they expect currencies or equities to underperform. Additionally, interest rates play a key role in gold pricing. When interest rates are low, gold becomes more attractive because it doesn’t yield interest, unlike bonds or savings accounts. However, when interest rates rise, gold may lose its luster as investors seek interest-bearing alternatives.

When it comes to accessing the commodities markets, traders and investors have several key products and markets available, each catering to different needs and risk profiles. 

Futures contracts offer a direct way to participate, offering leveraged exposure to commodity price movements. Futures are often utilized by speculators or businesses looking to hedge against future price volatility. While highly effective for active traders, futures come with added complexity and risk, including the potential for physical delivery of the underlying commodity. 

For those seeking a more accessible route, Exchange-Traded Funds (ETFs) provide a somewhat more simplified way to gain exposure to commodities. ETFs track individual commodities or baskets of them, allowing investors to buy and sell shares just like stocks, without needing to manage the intricacies of futures contracts. 

Finally, stocks of companies that produce or deal in commodities—such as mining firms or oil producers—allow investors to indirectly benefit from commodity price movements while potentially earning dividends or capital gains. 

Options offer another avenue for accessing exposure to commodities, whether it be options on stocks, ETFs, or futures. Options allow market participants to speculate on, or hedge against, commodity price movements using a wide range of strategic approaches. Each of these approaches offers unique benefits and risks, depending on an investor’s unique strategy, risk tolerance, and level of market engagement.

Trading and investing in commodities can offer significant opportunities, but it requires a structured approach and a disciplined approach to risk management. One of the first steps is to identify which commodity aligns with your financial goals and market outlook. After selecting a commodity, it’s crucial to develop a strategy and investment vehicle that fits your risk tolerance and market assumptions.

Some of the key considerations to help guide you through the process of trading and investing in commodities are outlined below.

Before entering the commodities market, assess whether it suits your financial outlook and risk tolerance. Commodities can be highly volatile, and instruments like futures come with added risk. Ensure that your risk profile aligns with the potential price fluctuations of commodities.

2) Conduct Thorough Research

As with any investing or trading endeavor, research is usually paramount. Understand the key drivers that affect prices, such as supply and demand, economic trends, weather, geopolitical events, and market sentiment. Staying informed through news, industry/sector reports, and forecasts is crucial for making informed decisions.

3) Develop a Market Assumption

Develop a clear market assumption - an informed hypothesis on what might happen in the commodities markets. This usually involves analyzing historical data, price trends, and relevant economic indicators. You can use technical analysis (examining charts and patterns) or fundamental analysis (focusing on broader economic factors) - or a combination of both - to guide this process. 

4) Choose the Right Product

After developing your market assumption, choose an appropriate product or market for your strategy. Depending on your experience, time horizon, and desired level of activity, you might trade futures, ETFs, options, or commodity-related stocks. Each product comes with unique risks and rewards, so ensure it aligns with your goals and risk profile. 

5) Identify Opportunities

Based on your research and market assumption, decide whether to go long (buy) or short (sell). If your outlook is more complex, consider options positions that may align with your assumption and risk profile. 

6) Actively Monitor and Manage Your Position

Once your position is deployed (e.g. open), closely monitor market conditions. Use risk management tools like stop-loss or take-profit orders to manage your positions. Be prepared to adjust if market data contradicts your initial assumption, or if unexpected events arise.

7) Plan Your Exit Strategy

A well-thought-out exit strategy is just as important as your trade entry strategy. Whether locking in profits or minimizing losses, having a predefined exit plan helps avoid emotional decision-making. Some reasons for exiting a position may include hitting your target price, an unexpected shift in market conditions, or reaching a stop-loss level. 

For futures traders, it’s important to close your position before the contract expires to avoid physical delivery of the commodity. Closing a futures position typically involves taking the opposite side of the trade before expiration (selling if you initially bought, or buying if you initially sold).

8) Review and Reflect

After closing your position, review the outcome. Analyze the effectiveness of your market assumption and consider whether a different approach/market might have produced a more desirable outcome. Also evaluate the effectiveness of your risk management approach. This process will help you refine your thinking, and help you optimize your approach going forward. 

Commodities attract investors and traders for various reasons, depending on their strategies and financial goals. One key appeal is portfolio diversification. Commodities often have a low correlation with stocks and bonds, meaning their prices can move independently from equity markets. For example, while stocks may face volatility, commodities like gold or oil may perform well, helping to balance and reduce overall risk.

Commodities also serve as an inflation hedge. When inflation rises, currency values decline, but the prices of physical goods like oil, gold, and agricultural products often increase. This makes commodities attractive during inflationary periods, helping to preserve purchasing power. Historically, hard commodities such as oil and metals have performed well during rising inflation, offering protection against economic uncertainty.

Another reason to invest in commodities is the exposure to global economic growth. As economies expand, particularly in emerging markets, demand for raw materials increases, driving up prices. Rapid industrialization in countries like China and India has fueled demand for energy, metals, and agricultural products, offering opportunities for investors to profit from global growth.

Volatility in the commodity markets can create trading opportunities. Prices are often sensitive to supply-demand imbalances, geopolitical events, and natural disasters, resulting in significant price swings. Traders who anticipate these movements can profit from short-term fluctuations.

Commodities also provide access to leverage, especially through futures contracts. This allows investors to control large positions with smaller capital investments, amplifying potential returns. While riskier, leveraging futures can enhance profits for those able to manage the associated risks.

Finally, commodities like gold and silver are considered safe-haven assets during periods of financial instability. Gold, in particular, is often viewed as a store of value when markets are volatile or uncertain. Investors turn to gold to preserve wealth during times of market turbulence, making it a valuable addition to portfolios in times of economic uncertainty.