Investments

How To Trade Commodities With Little Money

By David Krug David Krug is the CEO & President of Bankovia. He's a lifelong expat who has lived in the Philippines, Mexico, Thailand, and Colombia. When he's not reading about cryptocurrencies, he's researching the latest personal finance software. 11 minute read

It’s impossible to avoid encountering commodities. Raw materials are essential in the typical person’s daily existence, from staples like wheat and corn to energy sources like oil, natural gas, and precious metals. 

These fluctuations in their prices also affect everyone. The cost of gasoline, the food you feed your family, and the materials to construct or remodel your home are all affected by fluctuations in the commodity markets.

Because of the importance of a product or service to the financial markets and the economy as a whole, shrewd investors will always look for ways to make a profit off of fluctuations in the cost of that service or commodity. There is no shortage of eager buyers in any market, whether we’re discussing soybeans or gold.

However, is it wise to put your money into commodities? Then how do you get involved in commodity trading?

Understanding the Markets for Commodities

All sorts of commodities are exchanged on the commodity markets. It’s crucial to learn about the many commodity categories and their market behaviors before putting money into this sector.

The Different Commodities

A number of products can be found on the market at the moment, but they can be broken down into just three groups:

Energy

Products from the energy industry allow us to get where we need to go. They also supply the power needed to do things like heat or cool a house, prepare food, or use power tools like an impact wrench while doing some exciting home improvement projects.

Crude oil, natural gas, electricity, gasoline, and diesel fuel are all very popular energy commodities. However, this class includes anything whose consumption results in a change in energy state.

In order to protect themselves from inflation, many people invest in energy commodities. Inflation causes energy costs to rise, which in turn drives up the cost of the inputs needed to generate electricity.

Metals

Gold is often used as an introductory example of a commodity. Gold and silver are examples of metals, but copper, aluminum, and steel are also metals.

The two most common applications of metals are:

  1. To Hedger Against Inflation. Metals follow inflation in price increases, just like energy commodities. The same is true of copper and steel, two metals vital to the building industry.
  2. Sanctuary Locations. In times of uncertainty, many people turn to metals, especially precious metals, as a haven investment. When a bear market or correction hits Wall Street, investors flee the stock market for the relative safety of precious metals and other “safe haven” investments.

Soft Products

Soft commodities, sometimes known as agricultural commodities, are resources that can be cultivated, regardless of whether the final product will be consumed by humans. Soft commodities include a wide range of agricultural products, both edible and non-edible, such as corn, wheat, sugar, and cotton.

To protect against inflation, soft commodities are typically held in stockpiles. A can of coffee beans, a cotton T-shirt, and a bag of sugar are all examples of goods whose costs are likely to increase if inflation is taking hold.

What Drives the Commodities Market?

The commodities market is very different from what most people imagine. There isn’t a huge market where goods like grain, wheat, oil, and gold are sold to whoever has the most money. Real commodities aren’t exchanged at all on commodity exchanges.

Instead, participants in the commodities market trade derivative investments known as commodity futures to facilitate the exchange of these assets. First, let’s define futures and then discuss why they are used in the commodity market.

Locking in commodity prices, for both producers and consumers, is the primary goal of futures contracts. A futures contract is an agreement to buy or sell a certain quantity of a commodity at a set price at a future date.

It’s a win-win for the customer and the seller.

Advantages for the Seller

Futures contracts allow vendors to commit to a set selling price months or even years before the actual manufacturing of the commodity. This means the seller knows, before investing in manufacturing, how much money they will make for every pound or barrel of their commodity.

This is significant since commodity prices tend to fluctuate swiftly. Futures provide producers with peace of mind by reducing their exposure to a commodity’s price dropping precipitously.

Advantages for the Buyer

Additionally, with futures, the buyer is able to secure their purchase price. Most consumers who acquire commodities do so with the intent of reselling or incorporating them into other goods they intend to sell. They can secure a stable price for their primary inputs by trading in futures contracts.

A company that mass-produces cotton T-shirts, for instance, can use commodities futures to guarantee a stable cost for the cotton it employs. This means the textile manufacturer may confidently place their raw material orders without worrying about a possible increase in cotton costs.

Another illustration: jet fuel is a significant expense for airlines. Companies often use futures contracts to lock in jet fuel prices in advance, protecting themselves from the risk of price volatility and associated increases.

Introducing the Speculator

Large corporations aren’t the only ones that can benefit from the commodities futures market because of the ability to lock in pricing for large quantities of raw materials. Speculators are commodity traders that make a living off of futures trading by taking advantage of price swings in the market.

Commodity speculators have no intention of ever actually producing any of the commodities for which they have purchased futures contracts, and they also have no intention of ever actually taking delivery of any of the commodities for which they have purchased futures contracts. Instead, they engage in simple buy-and-sell activity, profiting from changes in the underlying commodity prices.

Speculators were once simply called “locals.” When neither manufacturers nor consumers were willing to sell, these wealthy merchants stepped in to help maintain market liquidity.

When it comes to the commodities market, today’s locals are largely irrelevant. Instead, liquidity is provided by institutional investors, who buy large quantities of commodities in the hopes of profiting from a price increase.

The accessibility of the commodities futures market to the everyday investor is another key development of the past few decades. Speculators with a wide range of motivations and resources can now participate in the futures market online, boosting market liquidity and capitalizing on price swings.

Applications of Commodities in Investment

There are three main attractions for commodity investors. 

Some of them are:

The Inflation Hedge

Just nearly everything on store shelves begins life as a commodity. Products like this usually increase in price along with inflation. So, they are a popular tool for protecting one’s wealth against inflation. Investments in energy, soft commodities, and metals are popular among those who wish to protect their wealth from inflation.

The Safe Havens

Precious metals and other commodities have traditionally served as haven investments. That’s because precious metals have always behaved oppositely to the stock market.

Many investors liquidate their holdings of precious metals when stock markets are rising so they can reinvest the proceeds in the soaring stock market. When demand decreases, the price of precious metals follows suit.

When equities fall sharply, as they often do during a stock market correction or bear market, investors often sell off substantial chunks of their equity holdings and put the proceeds into relatively secure assets such as precious metals. As a result, the demand for precious metals rises, and their prices follow suit.

Trading Possibilities

While long-term investors should give some thought to inflation hedges and safe havens, short-term traders typically don’t give them a second thought. Stock traders don’t have to worry about bear markets, corrections, or inflation because they don’t keep their investments for lengthy periods of time. 

Rather, they use technical analysis to try to make short-term price predictions that will lead to profitable trades.

Short-term speculators trying to capitalize on the frequent price swings find the market attractive because all commodities might present attractive trading opportunities from time to time.

Should You Make a Commodities Investment?

Most financial experts will tell you to spread your investments around, while some will tell you to put some of your money into commodities.

However, your investing plan, which should factor in the following, should cause the proportion of your portfolio allocated to commodities to fluctuate over time:

  • US Inflation Numbers. With a growing economy comes more prices and a weakening dollar. If inflation is expected to be above 2% per year, then a bigger proportion of the portfolio should be allocated to commodities.
  • The situation in the Economy and the Stock Market. When deciding how much to put into commodities, you should also consider the stock market and the economy as a whole. When a market correction or bear market occurs, it’s prudent to boost your holdings of safe haven assets until the storm passes. However, when market conditions are favorable, more of your portfolio’s resources should be invested in growth-oriented equities and less in safe havens like gold and cash.

How to Enter the Market for Commodities

Trading commodities on the futures market is a common first step, but it’s not your only one. In other words, investors who aren’t keen on actively trading futures contracts have four other options out of the five most prevalent methods to put money into commodities.

Exchange-Traded Funds (ETFs)

Trading on the stock market is a frequent technique for investors to obtain exposure to commodities. To invest in a wide variety of assets, exchange-traded funds (ETFs) collect capital from many participants and pool it together to buy and sell shares of underlying securities.

Commodity exchange-traded funds can be split into two categories:

  1. Investments for the Long Term Future. A number of ETFs offer exposure to commodity futures markets. This category of commodity funds represents the most challenging market segment (more on this below).
  2. Funds Invested in Common Stock. Equity funds invest in the businesses that mine and explore resources like oil and natural gas rather than in commodity contracts.

Concerns Regarding Commodity Futures ETFs

Similar to stock-focused ETFs, commodity-producing ETFs invest in companies that create commodities. Investing in futures contracts, while potentially lucrative, does present some unique challenges. 

So, here’s the deal:

1. Considering Futures

When purchasing shares of stock, investors pay whatever price is set by the market at the time. You make money if the price goes up, and you lose money if the price goes down. All of this is easy to understand.

The future is a little bit unique. You’re not actually paying the current market price, but rather a price set for the foreseeable future. It’s possible to lose money on a commodities investment even if the commodity’s value increases.

So, you decide to put your money into an exchange-traded fund that specializes in oil futures. Even if oil is selling for $100 per barrel at the time of your investment, the ETF will not buy or sell its holdings based on that price. For a futures contract on oil with delivery in three months, the ETF forks over $103 a barrel.

You might assume a $2 gain per contract if the price of oil increases by $2 in three months, from $100 to $102. Although the price of oil went up, the ETF still lost money because it bought contracts for $103 a barrel. To illustrate, the oil price did not increase to the point where it would have coincided with the futures contract’s buying price.

2. The Confusion is Increased by the Term Structure

Bond yield curves can be compared to the term structure of the futures market. The term structure illustrates how futures contract prices change as the time approaches maturity.

The term structure is considered to be in contango when the future price of a commodity is higher than the present price. Backwardation occurs when the future price is less than the present price.

Trading ETFs that concentrate on futures for energy and soft commodities, which are primarily driven by supply and demand, can be complicated due to the large price swings caused by contango and backwardation.

Exchange-traded funds tracking precious metals are more stable since their term structure is driven mostly by interest rates.

Investment Funds

Investments operate in the same way as exchange-traded funds in that they pool capital from a large number of investors before investing it in a diversified portfolio of companies as outlined in their prospectus. To facilitate investment in the commodity market, a number of mutual funds have been established.

In general, these funds avoid future transactions. Instead, they put their money in the stocks of commodity-producing corporations. Companies in this sector include miners, farmers, and manufacturers.

Personal Stocks

If you’d rather not manage a portfolio but are interested in the commodities market, you’re in luck. Stocks of companies involved in mining, oil exploration, and other basic resources are some of the best available on the market.

Just like with regular equities, not all commodities stocks are made equal. Particularly when investing in single stocks, it pays to conduct one’s homework and learn as much as possible about the companies and their products before making a purchase.

Index Funds

If you’re looking for diversified commodity exposure without the hassle of researching individual stocks, index funds are a terrific alternative. The Bloomberg Commodity Index and the Dow Jones Commodity Index are two of the most reliable commodity price indices available.

In order to diversify your portfolio without spending a lot of time on research, you may want to consider purchasing an index fund that tracks certain commodities benchmarks.

Disadvantages and Advantages of Trading and Investing in Commodities

You should weigh the advantages and disadvantages of investing or trading in commodities before you do so. 

Significant examples include:

Commodity Advantages

  1. There Are Commodities that Can Be Used as Havens of Safety. In nearly every asset-allocation plan, safe havens play a crucial role. They contribute to a more stable and less volatile environment. In addition, they tend to increase in value during market downturns, so reducing the extent to which drawdowns can occur. Rare metals, such as gold and silver, are highly sought after as investments.
  2. Growth. It seems to reason that with a growing global population and standard of living, commodity demand will increase. Given that the equilibrium between supply and demand determines the price of commodities, the rising demand has already resulted in and will continue to result in, a rise in the value of these goods over the long term.
  3. Safety against Inflation. A general increase in product costs will inevitably lead to a corresponding rise in the cost of raw materials. Even if the value of the dollar could fall as a result of inflation, the price of goods usually rises at such times.

Commodity Disadvantages

  1. Volatility. The price of most commodities is notoriously volatile, in contrast to the relatively stable value of precious metals, which can help to keep a diversified portfolio from experiencing excessive swings in value. The volatility of commodity prices has been estimated to be two to four times that of stocks and bonds, respectively.
  2. The Lack of Income. Investment and trade in commodities provide a return proportional to the appreciation of the commodity’s price. In addition to price appreciation and a wider range of possible returns, other assets, such as stocks and bonds, may offer dividends or coupon rates. As an investment, commodities provide no return to the owner in the shape of dividends, interest, or anything else.

Bottom Line

If you don’t already have some exposure to commodities in your portfolio, you should start. Despite the fact that commodity futures trading is not for everyone due to the high level of risk involved, diversifying your portfolio with precious metals is a good idea.

In the long run, astute investment choices in commodities other than gold can pay out handsomely. Because of the extreme volatility of the commodities market, however, it is essential that you fully inform yourself before making any investments.

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