Saturday, September 24, 2022

What is…? Commodities

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A commodity is a basic product that is interchangeable with other products of the same type (fungible). For example, coal is a commodity as it does not matter what company the coal comes from or how it is obtained, it will still simply be coal. A product like a tablet computer, however, is not a commodity. A Samsung Galaxy Tab is clearly not interchangeable with a Microsoft Surface Pro.

So what does this mean to traders and how does learning about commodities help to maximize profits? As with most things that are tied to financial trading markets including currencies, indices and stocks, commodities can be traded by retail traders. Commodities can be a very useful area for a technical trader who is looking to expand into fundamental trading. This is because they are heavily influenced by international politics as well as news and weather events.
Technical and fundamental trading will be explained in more detail in What is…? episodes 13 and 14.

SAME, SAME, BUT DIFFERENT

While each individual commodity is uniform across all markets, different commodities will behave in different ways and react to different events. Commodities are generally sorted into four categories:

Metals:

Metals can be very reliable and are often used by institutional traders to hedge (protect/insure) themselves against volatile markets. The most well known metal commodities are Gold and Silver, however Platinum, Palladium, and Copper are also reasonably well traded. Rare Earth metals such as Lithium, Cerium, and Neodymium are increasing in value due to their use in batteries, electronics, and lighting. Unfortunately, the only ways to trade them currently is to invest in companies that produce them or by trading a rare earth metal ETF. ETFs will be discussed in detail in What if…? Episode 7.

Energy:

Energy commodities include two types of Crude Oil (West Texas and Brent), Natural Gas, RBOB Gasoline, and Ethanol. Less common energy commodities include Heating Oil and Uranium. Renewable energy is beginning to be traded, however is restricted due to the nature of the industry. While Coal and Oil are measurable, the sun and wind are not, so identifying a unit of these commodities is difficult. Currently there are a number of ETFs focusing on renewable energy, but it can be difficult to find a broker that allows you to trade them. Another way to invest in renewable energy is to invest in the companies that produce it.

Agriculture:

Agricultural commodities are wide ranging and come in very different shapes and sizes. The basic definition is that they are crops produced on farms and plantations but they can expand a bit beyond this. Orange Juice futures are one of the most widely traded commodities, yet this would appear more of a consumable good than a raised crop. Effectively orange juice is traded instead of oranges because it can be frozen and therefore is less perishable. When it comes to agricultural commodities, there is always a way to trace them back to something grown on a farm.

Livestock:

Live cattle, feeder cattle, and lean hogs are clear examples of livestock commodities, but so are milk (dairy), leather, wool, and eggs. Livestock commodities include all animals raised on farms and their bi-products. Livestock is a very similar commodity to agriculture, and is often merged into the agriculture category. Anything that is a livestock commodity can be traced back to a farmed or caught animal at some point.

TRADING A COMMODITY

So now that we know that commodities are actual goods that can be purchased, how do we trade them? The average retail trader probably doesn’t want to take delivery of 10,000 barrels of West Texas Crude Oil so the actual purchase of the commodity is out of the question. However, there are a few ways to trade commodities.

The first two methods are based on current price action and they are ETFs and CFDs. ETFs and CFDs will be explained in What is…? episodes 7 and 8. Traders will need to find a broker that offers these services for the specific commodity you wish to trade. Once found these brokers will allow a retail trader to speculate on the current price of a commodity in a similar way they would with FOREX or Indices (CFDs) or shares (ETFs).

The next two methods are futures and options trading. Both of these methods use a futures exchange price as a basis for the trade. Futures and Options will be explained in What is…? episodes 9 and 10. Futures trading can be a difficult experience as when the deadline for the current contract arrives (the expiry date) if you cannot take delivery you will need to look to roll over the contract or sell it at the going rate.

Many traders discovered this exact problem on Monday the 19th of April, 2020. With oil being used less in a COVID-19 world, producers were making more than consumers wanted. Retail traders became stuck with oil contracts they were not able to take delivery of. These traders ended up having to pay others to take the contracts off their hands. Not a great day for a trader who bought the contract and then had to pay again to sell it. It only lasted two days and was back at $20 a barrel by the end of the month. Nevertheless, it was a considerable wake-up call for those who thought there was a floor to the price of oil. Fortunately this is a one in a lifetime type scenario and not likely to ever impact most traders.

SO WHY TRADE COMMODITIES?

The first reason to trade commodities is that they can move very quickly in response to market events. They are a high-risk/high-reward form of trading. A well researched trader will be able to see a potential market movement before it happens. Commodities are often guided by political decisions, research developments, company performances, and weather patterns. Good traders will usually specialize in one or two primary types of commodity to ensure they are able to be fully aware of all of the factors of influence.

Commodities are easy for a trader to visualize and understand. They are driven by supply and demand, which is a principle drilled into most people from childhood. Commodities are also physical things we can relate to. It is easier to understand the concept of owning an ounce of Gold than a unit of a measurement tool (Indices).

Trading times vary for commodities. Oil, Gas, Gold, and Silver trade from 6pm Sunday to 5:15pm Friday EST. Agriculture Commodities are generally more restrictive with several breaks in trading. These scheduled gaps in trading last from 2 to 6 hours each day throughout the week.

Series 1 – What is…?
Episode 3 – Commodities
Next – Cryptocurrencies

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