Commodity Trading: How To Get Started

Commodity trading is an ancient practice that has been going on in the world as long as people have been around. In today's terms, a commodity is any basic good that is interchangeable with another of the same type of good. Examples of commodities include wheat, soybeans, gold, silver, natural gas and oil.

What Is Commodity Trading?

Commodity trading began to modernize along with advances in the stock market. The Chicago Board of Trade was the first commodity exchange in the United States, opening in 1848. There are currently four main commodity exchanges in the United States:

• Chicago Mercantile Exchange (CME)
• New York Mercantile Exchange (NYMEX)
• Intercontinental Exchange (ICE)
• Kansas City Board of Trade (KCBT) 

Today, commodities trading is typically done in what are called "futures." People will buy and sell a contract that gives them the right and responsibility to take ownership of a certain quantity of a commodity on a certain date. The owner of the contract at its date of execution will receive the stated amount of that commodity.

Commodity Examples

Here are four of the major types of commodity examples that are often traded.

Energy

Energy commodities include natural gas and crude oil and their derivatives. Energy commodities, perhaps more than any other type, are influenced by more than just supply and demand. Global conditions play a major role in determining the price of energy futures. Instability or war in the Middle East (a major producer of oil) can lead to higher prices for energy commodities. Additionally, the Organization of the Petroleum Exporting Countries (OPEC) is a collection of many of the major oil producing countries. OPEC sets the total amount of oil that is produced by its member countries, which has a major impact on the prices of crude oil and natural gas futures contracts.

Metals

Precious metals like gold and silver are also popular in commodity trading. The price of gold and silver shifts not only with supply and demand, but with changes in global monetary policy. Owning gold and silver instead of other forms of currency can be a hedge against inflationary monetary policies. If you're considering investing in precious metals, we have more information about whether gold is a good investment.

Agriculture

Many different agricultural products part of commodity trading. Soybeans, coffee, wheat and corn are traded on commodities exchanges. Many large consumers of different types of commodities may trade in agriculture futures to keep their supply costs constant. For example, Starbucks may buy or sell coffee futures as a hedge against their coffee supply.

Animal Agriculture

Animal agriculture is another one of the commodity examples. Pork and cattle and their derivatives are the primary types of animal agriculture traded on commodity exchanges. Again, it's common for large consumers of these products to buy and sell on mercantile exchanges in order to keep their supply costs from spiking too drastically.

Pros And Cons Of Commodities Trading

Before considering starting in commodities trading, it's important to look at some of the pros and cons.

The Pros

Here are some of the pros of commodities trading:

• Security against inflation: Inflation is a big concern for many types of investors. Owning commodities can help protect against inflation.
• Diversification: Having a diverse class of assets is an important part of a sound financial strategy.

The Cons

Here are some of the cons of commodities trading:

• Extreme volatility: The commodity trading market, more so than even the stock market, is subject to extreme volatility. Traders should be aware and make sure that their overall portfolio can handle the volatility.
• High leverage: This can be both a pro and a con, but many commodities trades have very low margin requirements. This makes it easy to lose large amounts of money if a trade turns against you.
• Lack of income generation: Commodities trading does not produce income like owning real estate or dividend-producing stocks.

How To Trade Commodities

While you do have the option to trade commodities by physically purchasing the commodity in question, in most cases that’s not how commodities trading is done in the 21st century. Most commodities trading is done online. Here are a few trading strategies.

Commodities Futures Strategy

Many companies invest in commodities futures as a way to hedge against future costs in their supply chain. For example, an airline might invest in crude oil futures to ensure that if the price of airplane fuel goes up that it does not have an outsized effect on their day-to-day operational costs. If you plan to invest in commodities futures like this, it can be a good idea to select a competent brokerage to help advise you.

Commodities In The Stock Exchange

Another trading strategy is to do so by buying and selling commodity companies in the stock exchange. Sunoco Oil and Gas (SUN) is an example of a company that you can purchase stock in. While part of Sunoco's business is retailing gasoline to consumers, they also have a large refinery business, and are a way to invest in commodities indirectly. Mining companies like Yamana Gold (AUY) are another way to invest in commodities in the stock exchange.

Exchange-Traded Funds And Notes In Commodities

Many commodities have an exchange-traded fund (ETF) that tracks the rise and fall of prices in their particular commodity. The iShares Silver Fund (SLV) is an example of an exchange-traded fund for the metal silver. This can be an easier way to invest in commodities if you manage your own portfolio.

Mutual Fund Investments In Commodities

If you want to trade in commodities but don't want to deal directly with futures contracts or specific companies, a mutual fund that specializes in commodities may be a good option. A mutual fund is similar to an ETF in that you can buy and sell shares in one specific fund to capture a bigger and more diverse section of the market.

The Bottom Line

Commodity trading, like investing in cryptocurrency, is not for the faint of heart. There are many valid reasons for investing in commodities, like diversifying your portfolio and hedging against inflation and future supply costs. But if you do trade in commodities, you'll want to make sure that you learn more about your own investing risk tolerance before getting started.