Commodity Trading Basics

Investments in equity or debt are fairly common practices in the financial markets. However, it is the investment in commodity markets that has seen a significant rise in the past decade. This sophisticated form of investing adds a whole new dimension to markets. While it can fairly diversify your portfolio, its volatility and risks are relatively higher. Commodity trading basics provides an ideal asset allocation and helps to hedge against inflation. The growing investors’ keenness towards commodity trading has prompted us to write this article on the basics of the same. A commodity is a product that is found naturally or is grown. It is usually a generic, largely unprocessed, good that can be processed and resold. These goods and products include various foods, precious and industrial metals, livestock, as well as fuels that are exchanged and traded on the financial markets. For example: gold, crude oil, cattle, lumber, wheat, cotton, sugar, etc are all commodities. Undeniably, commodities play a prominent role in our day-to-day lives and therefore, forma substantial part of national and international marketplace. So commodity markets are nothing butmarkets where such commodities are traded on exchanges, where prices are based on supply and demand. It is similar to stock trading but instead of buying and selling shares of companies, investor buy and sells commodities in pre-specified standardized contracts. rnThere is variety of instruments that are traded in the commodity marketplaces; however, below I have listed the most popular methods. Spot Trading, as the name suggests, is any transaction where delivery either takes place immediately, or with minimum lag between the trade and delivery due to technical constraints. It involves prompt exchange of goods for money. For its implementation to commodities, the marketsrequire the existence of agreed standards so that trades can be made without visual inspection. Forward Contract is an agreement between two parties that specifies the transfer of ownership of a given quantity of a commodity at some fixed future date in time. The fixed price today is known as the forward price. Thereby, no cash changes hands today, but the contract is executed on the expiration date by the exchange of goods for cash. Futures Contract is essentially the same as a forward contract but is standardized and transacted through a futures exchange. The buyer and the seller accept the terms in regard to product, grade, quantity and location and are free to negotiate the price. Futures trading is one of the most common form of trading commodities today. Up till this point, all aforesaid instruments create a binding obligation of the parties. Option Contract, on the other hand, allows its participants the option to execute the transaction or not. An options contract,therefore, gives the commodity trader the right, but not the obligation, to engage in a transaction. The buyer of the option gains the right, however, the seller incurs the corresponding obligation to fulfill the transaction. The price of the option is derived from the underlying asset (commodity) and usually based on the Black-Scholes model. Undoubtedly, options trading is one of most common and inexpensive ways of trading commodities. Oftentimes, commodity traders use commodities to hedge their trades. For instance, let’s suppose that you have invested in a silver mining stock. However, the region where the company has its mines is experiencing extremely bad weathers and as a result, has flooded its mines. The work has been indefinitely stalled. Surely, this will build a bearish sentiment around the company’s stock; however, in line with the same new, it can be derived that the supply for silver will reduce as well. Thereby,pushing up the silver prices on commodity markets. So had you invested in silver, it will make up for your loss in equity markets with profits from the commodity markets. This technique is also a common practice in farming sector, where poor harvest due to weather or insect, is somewhat frequent occurrence. In comparison to the equity market, commodity trading is a lot faster. So good research, good guidance and/or good instinct can make investor money a lot faster, however, a lot can be lost just as fast with a worthless contract. Therefore, it is important to be extremely careful while trading commodities. Educate yourself about the markets and the particular commodities you interested in, as much as possible. Also, evaluation of one’s financial situation, risk appetite, trading personality and investment objective would be helpful considerations. Many experts also recommend selecting or devising a trading strategy before beginning to trade. Being a high-risk investment, it is also advisable to establish a demo commodities trading account and test your trading strategy before putting any money at risk. As a bottom line: don’t be lured into commodity trading just for its great earning potential, rather learn the art of trading commodities first, and only then you would observe consistent gains.