What Are Commodities?
Commodities are products that are available from multiple sources when there is very little difference between items coming from one producer and another producer. For example, while you can usually tell the difference between computers built by two unique manufacturers, a bushel of wheat from one farmer will be practically identical to a bushel of wheat from another farmer, even when coming from completely separate regions of the world. Commodities trading is a popular way to speculate on the future value of goods, and since the conditions that affect commodities prices vary widely from those that affect currency and indices trading, investors frequently flock to commodities when trying to manage portfolio risk. There are four main categories of commodities available for trading: energy, metals, livestock, and agriculture.
The Energy sector is primarily based on oil and natural gas. Due to the influence of OPEC, the cartel of oil-producing countries located mostly in the Middle East, this subgroup is the most heavily influenced by political considerations outside of market conditions. Traders who specialize in these commodities need to check for any signs that production will be manipulated in an effort to artificially raise or lower prices.
The Metals sector is represented by gold and silver, as well as by the industrial metals used in manufacturing, such as copper and aluminum. Due to their rarity and consistent demand, gold, and to a lesser extent silver, are considered to be more stable ways of protecting wealth when currencies are experiencing high volatility. Therefore gold and silver prices can be used as a way of estimating the confidence of traders in terms of the stability of the world’s economic and political status. The prices of the manufacturing metals fluctuate in relation to the laws of supply and demand. When world production is increasing, these prices go up. When there is a slowdown in the manufacturing sector these prices go down. Since production usually increases during times of economic growth, metal prices can serve as a proxy for upcoming periods of economic booms and recessions.
The agricultural sector is reliant more on changing weather conditions, as many of the countries where the world’s supply of grains, beans, cocoa, and sugar are grown are vulnerable to extreme conditions such as drought, flooding, and hurricanes. While meteorologists have made vast improvements in predicting the weather, this is still a chaotic system. Additionally, climate change has made the models unreliable, as seasonal patterns shift due to increased carbon emissions and deforestation. Traders who speculate in agricultural commodities try to keep in touch with how current weather conditions will affect crops months in advance.
The livestock sector is one of the most complicated of the commodities to trade, as it takes into account global demand for meat, along with the costs associated with feeding and housing the animals. Easier distribution has made meat available to more people throughout the world than ever before. However, there is a growing recognition that livestock contributes to a decline in the environment, as animals discharge the greenhouse gas methane, leading to global warming. Additionally, it takes several acres of land to sustain production of cattle and hogs. This has led to deforestation in several areas, including a marked culling of the Amazon rainforest. The U.N. and the World Health Organization are heading up initiatives aimed at decreasing meat consumption, which could act as a brake on rising prices.
What Are the Risks of Commodities Trading?
Traditional commodities trading usually has a long horizon, with orders being placed months before the final price is known. This is completed through the use of futures contracts, which expire on a specific date. During the time between the original order and the end of the contract, traders face exposure due to changes in market conditions from either purposeful manipulation or unforeseen circumstances such as weather or local political conflicts. Due to this, investors sometimes limit their participation in the commodities market to a fairly small percentage of their portfolio.
One way to minimize the risk of trading commodities is to switch to CFD trading. With online CFD trading, the investor only needs to choose the correct price direction for the commodity and purchase an according contract at a much lower price than the commodity itself. He will then collect the profit on the difference, as if he owned the commodity, if he choose the correct direction.