What Is Commodity Trading and How To Trade

In our previous chapters, we covered the basics of what a commodity is, how the commodity market functions, its derivatives in the form of F&O and more. Now, as a potential investor, you may be wondering, how can I trade in these commodities? Or, are there any risks to trading commodities? 

In this chapter, we will answer all these questions and more. Let’s get started!

What Is Commodity Trading?

Commodity trading refers to the buying and selling of raw materials or primary goods, agricultural products, metals and more in financial markets. These can include metals (gold, silver, etc), energy resources (crude oil, natural gas), agricultural products (wheat, rice, pulses, spices, etc) and other tangible goods. 

Commodity trading allows buyers and sellers to trade standardised contracts for delivery for a specific quantity and quality of commodity in regulated exchanges or over-the-counter markets. 

Now, you may be wondering – How do I invest in commodities? Well, it's not very complicated. Below, we break down the most common investing channels in the commodity market. 

How To Invest in a Commodity Market?

• Physical Method: You can quite literally (and physically) buy tangible commodities such as agricultural products, gold, other metals and more. But, before you physically invest in any commodity, make sure you conduct complete research on market conditions, demand, storage, logistics, and more. 
• ETFs: In the context of commodity markets, ETF or Exchange Traded Funds track the performance of a basket of commodities or one specific commodity. The ETFs, just like the stock markets, are listed, allowing investors to conduct trade in them. For instance, the UTI Gold ETF tracks the spot price of gold.The advantage of investing in a commodity ETF is that one need not physically own the commodity and can simply gain exposure to the underlying price movement. You can open a brokerage account with your stockbroker and start trading commodity ETFs quickly. 

• Commodity Mutual Funds: These are mutual funds specifically designed to invest in a class of commodities. They can be of many types, such as index funds, combination funds, etc., and are managed by expert fund managers. So, the risk is slightly on the lower side. 
• Securities: You can indirectly invest and reap the benefits of commodities by investing in securities of their classes. For instance, if you are bullish on energy, you can invest in energy-related stocks and reap benefits like directly investing in natural gas and oil commodities. 

Advantages of Investing in Commodity Trading

• Portfolio Diversification: Commodities have historically shown to have a low correlation with traditional asset classes. So, if, say, the stock markets are crashing for some reason, the commodity markets don't need to follow suit. In fact, it might be quite the opposite! And for this reason, commodities can be considered an excellent way to diversify your portfolio. Traders can invest in commodities to minimise their overall risk and enhance return. 
• Profit Potential and Liquidity: Commodity markets are highly volatile. While this may appear risky to certain traders, skilled traders who can accurately anticipate price movements can capitalise on price fluctuations, spot entry and exit points and make profitable trades. Also, do remember that commodities can provide you exposure to the global market and its dynamics, thereby increasing your trading play area. Also, as we account for profitability in commodity trading here, liquidity is another parameter you must consider. Commodity markets are highly liquid. This means easy entry and exit for traders, which in turn can help increase profits. Also, high liquidity can reduce the risk of not being able to execute a trade properly. 

• Inflation Hedge: Commodities, for the longest time, have been considered an effective hedge against inflation. Investing in commodities can help compensate for the erosion in purchasing power caused by inflation. Gold, traditionally viewed as an anti-inflation asset, can be an apt example here. 

Now that we have given you reasons to invest and explore the commodity markets, let’s not forget to examine the potential downsides to commodity trading. 

Risks Associated With Commodity Trading

• Market Risk: Commodity markets, as we covered in our previous chapters, are influenced by a variety of market factors, such as global economic conditions, political instability and regulatory changes. This volatility exposes traders to the risk of significant price movements, potentially resulting in substantial gains or losses. For instance, do you remember the scarcity of onions and tomatoes a few years back in India, followed by subsequent price rises? Also, do you recall the global rice shortage that hit the global economy last year? You can also take the shifting crude oil prices due to changing OPEC policies as an example. So, as you observe, the constantly changing macro and micro environment directly impacts the commodity markets. 
• Weather Conditions: Agricultural commodities can be directly impacted by weather conditions such as drought, floods, hurricanes and natural disasters. These can directly affect the quantity and quantity of crops produced. And, as supply and demand dynamics change, it can cause potential fluctuations in the commodity market. 
• Operational Risk: Commodity markets involve complex storage, logistics and delivery processes. Traders are constantly exposed to the operational risk involved in these processes – delays, decay, unforeseen accidents, logistics failure and more. Imagine a situation where a state in India has had a rapid decay of 80% of its wheat storage. It could be catastrophic for the state, consumers and producers. Do you see how such situations can impact the timely execution of trades and increase the risk of losses? 

• Counterparty and Financial Risks: Commodity trading rests on a complex web of interaction between producers, consumers, traders, brokers and exchanges. If even one party fails to keep its promise or default, it can disrupt trading and manifold your risk many times. Now, let’s look at the financial risk. As you understand, commodity traders often use leverage to enhance their trading positions, and while this can amplify profits, it also can magnify losses. Traders must, hence, carefully manage their exposure and have sufficient capital to cover margins and losses. 

• Regulatory Risk: Commodity trading is subject to various regulations and legal frameworks, as covered in the previous chapter. Changes in these regulations or compliance failures can expose traders to high legal and financial risks. 

It is not a hidden fact that commodities markets can help you make enormous profits. However, the downsides of commodity trading are very high. You must consider the above-mentioned risks before dipping your feet in this highly liquid yet risky market. 

With this, we end the module of commodity trading. We hope you now fully understand the functioning of commodities, markets, their derivatives and more.