Guide to Commodities

• A commodity is a raw material or primary agricultural product that can be traded on the commodity market
• Examples of commodities include gold, silver, sugar, corn, livestock, crude and heating oils, and petrol
• Traders can participate in the commodity market by purchasing commodity futures contracts, trading assets physically, or by investing in stocks of related corporations
• The purchase of commodities can diversify portfolios and potentially protect stock traders’ capital in inflationary environments

What are commodities?

Commodities are raw materials or primary agricultural products used to produce finished goods for human use or consumption. They can be considered the building blocks in manufacturing processes, and they can be bought and sold on online exchanges with other commodities or with currency. Types of commodities Commodities can be separated into four main categories.

1. Metals

Commodity metals include industrial metals such as bronze, iron ore, aluminium, copper, zinc, and precious metals such as gold, silver, and platinum.

2. Agriculture

Agricultural commodities are crops and farming by-products, such as sugar, grain, corn, cotton, palm oil, and rubber.

3. Livestock

Livestock commodities are domesticated animals raised in an agricultural setting, such as cattle, lambs, and pigs. Livestock animals are used for three purposes: meat production, accessory production (such as wool, leather, and silk), and produce other products for consumption such as milk, honey, and cheese.

4. Energy

Energy commodities include crude and heating oils, natural gas, petrol, and coal. They also include forms of renewable energy, such as solar and wind power.

How does commodity trading work?

Commodities were traded long before the establishment of the modern financial market. Ancient empires traded metals and textiles and established trade routes for this very purpose—so they could journey places to perform the exchange. Today, commodity assets are not traded physically. Instead, traders bet on their price movements in an international exchange online. Below are three common ways commodities can be traded, but bear in mind, they are not the only ways.

Commodities futures

A popular way to trade commodities is with futures contracts. This takes place on a futures exchange. A futures contract is an agreement between two parties to exchange a certain number of goods and money in specific currencies. Commodities are traded on their underlying physical price at the time of drawing up the contract, with the prospect that these prices will increase or decrease when they are bought or sold in the future. Traders who predict a commodity will increase in price later will buy futures or go long, and traders who predict it will decrease in price later will sell futures or go short.

Commodities stocks

Traders can also participate in commodities trading by buying stocks of commodities companies. These are corporations and businesses directly involved with obtaining, refining, and holding commodity assets. For example, traders who want to get involved with crude oil can buy the stocks of an oil drilling or fracking company. Those interested in exchanging wheat, corn, and grains can buy into food production and other agricultural companies. The price of these stocks will fluctuate according to the supply and demand of their respective commodities. However, this is not the only factor that moves stock prices. Other reasons, such as a company’s management and market share, can affect the prices of their stocks. Commodities stock trading is a good option for traders who want to dip their toes into the commodities market without having their entire capital rely on the movement of those assets.

Physical commodity purchases

Traders on commodities exchanges do not usually physically exchange the goods they buy and sell. If they did, there would be a great difficulty and costly transaction fees to transport thousands of barrels of crude oil or hundreds of livestock around the world. However, a physical exchange is possible in some cases with precious metals such as gold and silver. With slightly higher transaction costs, individual traders can take possession of the metals they buy in the form of coins, jewellery, and gold bars.  

Benefits of commodity trading

Diversification of portfolios

The prices of commodities fluctuate by the supply and demand of the respective assets, and they have low or no correlation with the fluctuations in the stock market. This is a good way for traders to diversify their portfolios and divide their capital, so they do not put all their eggs in one basket. There is also a vast array of commodities traders can trade, from grains and petrol to precious metals. As many commodities are raw materials required for the production of goods, they are always in demand.

Protection against inflation

This diversification of portfolios will come in handy for traders in times of inflation. In these situations, stock prices plummet. This is because high inflation rates go hand in hand with high borrowing costs, which leads to lower incomes for businesses and, subsequently, fewer profits among shareholders. Inflationary environments, on the other hand, increase the prices of commodities. This is due to the increased demand for raw materials to manufacture finished goods. Traders who participate in both stock and commodities trading will find that while they are losing money from their plummeting stocks, they can continue to protect their capital by hedging against the impact of inflation with help from their commodities investments.

Security in trading

Commodities are traded on an electronic platform that all market participants can access anonymously. The platform enables broad-scale participation without intervention during the buying process, and asset prices are driven by supply and demand without room for manipulation. This promotes fair price discovery—the process when the price and quantity quoted by the seller match that of the buyer and increases security in trading.   The bottom line Investing in commodities is an excellent way for traders to protect against inflation and can be a diversification option in portfolios. Commodities trading can also make a lucrative option when mastered, as essential goods and raw materials are always in demand for as long as we live. Here at Rakuten Securities Australia, our commodity trading options include UK and US Crude Oil, UK and US Crude Oil +$100, and precious metals such as XAU/USD (Gold/US dollar) and XAG/USD (Silver/US dollar). They are available on our MetaTrader 4 platform. As all trading activities contain risk, feel free to try a free demo account to practise trading before creating a live account.