How to Choose the Right Commodity to Trade

The commodity markets are crucial to commerce. The global economy might collapse without the energy to move and build things, metals to manufacture, and grains to create food. Choosing the right commodity to trade requires knowing why a commodity might move and the liquidity available to trade that commodity.

Several strategies can be employed to generate profits from commodity investing. You can use fundamental analysis reflecting a specific commodity's supply and demand. You can employ a macro strategy that evaluates economic growth and how that will impact the price of a commodity. You can also use technical analysis to determine the future movements of a commodity price. You can even trade one commodity versus another commodity, which is a market-neutral strategy. Before trading commodities, select the commodity that fits your investment style.

There are also many different platforms available to invest in a commodity. You can trade a physical commodity. You can use a futures exchange as well as the over-the-counter market. You can also trade using a contract for differences or through a commodity ETF.

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What are Commodities?

Commodities are essential goods used in commerce that are interchangeable with other goods of the same type. Commodities include crude oil, natural gas, gold, silver, corn, and wheat. Commodities are physically exchanged, as well as traded on regulated futures exchanges. Commodities are also sold via contracts for differences through the over-the-counter market and exchange-traded funds.

What is Physical Commodity Trading?

Physical commodity trading is the buying and selling physical goods such as oil, gas, metals, grains, and other raw materials. It involves purchasing and selling commodities for imminent delivery or future delivery. Physical commodity trading can be for commercial practices or as a form of speculation, as traders attempt to profit from price movements in the underlying commodities. Another form of physical commodity trading is arbitrage. Transportation arbitrage is where a commodity trading merchant attempts to purchase a commodity in one location and move it to another where they can sell it at a higher price. The merchant can generate an arbitrage if the purchase price plus transportation and storage are less than the sale price.

What is a Futures Exchange

A futures exchange is a central marketplace where buyers and sellers of futures contracts can meet to trade. Futures contracts are agreements to buy or sell a particular asset at a predetermined price at a specified time. Futures exchanges provide a platform for traders to speculate on the future price of an asset, hedge against price risk, and manage their portfolios. The most commonly traded futures contracts include crude oil, natural gas, gold, silver, copper, corn, and soybeans. Some futures contracts are physically delivered. These types of futures contracts require that the seller provide the buyer with a commodity with specific criteria on the delivery date. The buyer is required to exchange money for that commodity on that date. Before delivery, items sold and purchased via an exchange can be stored in a regulated exchange warehouse or storage facility. You must open a futures account with a broker to invest in commodity futures.

What is Over The Counter Commodity Trading

Over-the-counter (OTC) commodity trading is buying and selling commodities through a network of dealers instead of on a regulated exchange. Large institutional investors, such as hedge funds, often use OTC commodity trading to gain exposure to commodities without going through the exchange process. OTC commodity trading is also used by smaller investors who may not have access to the exchanges or who may not want to pay the fees associated with exchange-traded commodities. Over-the-counter securities are generally financially settled. The contract between the buyer and the seller has no exchange, and the underlying instrument used to determine the contract value can be customized.

What is Contract for Differences Commodity Trading

Contract for Difference (CFD) commodity trading uses financial security to invest in a commodity. A CFD is a financial security that tracks the underlying movement of certain commodities. An investor in a CFD is only responsible for the difference between the purchase and sale price and is not responsible for taking or making delivery of a physical commodity. To invest in a CFD, you must open an account with a CFD broker.

What is a Commodity Exchange Traded Fund

A commodity exchange-traded fund (ETF) is an investment fund that tracks the price of a specific commodity or group of commodities. It is traded on a stock exchange, just like a stock, and its value is based on the price of the underlying commodity. Commodity ETFs expose investors to the price movements of commodities without having to buy and store the physical commodity. In many instances, commodity ETFs will hold futures contracts.

What Commodity Trading Strategy Should You Choose

Since several different instruments and platforms are available, you need to choose the one that fits your accessibility and trading style. For example, physical commodity trading requires a lot of capital as it requires you to purchase and store a product before you can transport it to another location. Businesses are generally more likely to trade physical commodities, but you might consider this endeavor if you have access to certain products.

Futures contracts, CFDs, and ETFs are all financial products. Some futures contracts also provide physical delivery, but you can exit your position before the settlement period or roll it to another contract to avoid dealing with the delivery process. For example, the West Texas Intermediate futures contract the Chicago Mercantile Exchange offers is physically delivered. Suppose you hold the contract into the settlement and delivery period. In that case, you will be required to take delivery of WTI crude oil in Cushing, Oklahoma, at one of the CME's regulated storage facilities.

Fundamental and Technical Analysis

Financial securities such as CFDs, ETFs, and Futures contracts allow investors to use the risk management and a trading strategy to enter and exit commodity markets without the headache of physical delivery. For example, fundamental and technical analysis are two of the more popular types of research used in gold trading.

Commodity fundamental analysis includes determining supply and demand. For many commodities, this process is global. Commodity analysts often use a balance sheet describing the total supply and use of a commodity and what is expected to be left over at the end of a marketing year.

Another type of fundamental analysis is macro analysis. Instead of determining the specific likely supply and demand, you determine if future global growth or contraction will occur. You might need to incorporate interest rates and stimuli to evaluate if there is likely to be economic growth. Commodity prices are more likely to rise when growth occurs as consumption increases. The reverse is true when economic growth contracts.

Another popular type of analysis is technical analysis. Technical analysis is the study of past price movements to determine the future direction of a commodity. Technical analysts often use charts to determine support and resistance levels. Support and resistance are levels in the market where the price of an asset has difficulty in either breaking through or falling below.

Technical analysts might also use statistical studies such as trend following and momentum. Popular trend-following strategies include a moving average crossover. A moving average crossover is a trading strategy that uses two different moving averages to identify a trend in the price of an asset. When the shorter-term moving average crosses above the longer-term moving average, it is a signal to buy the commodity. Conversely, when the shorter-term moving average crosses below the longer-term moving average, it is a signal to sell the item.

Momentum indicators can also tell you when a commodity is overbought or oversold. For example, the relative strength index (RSI) is a momentum oscillator that measures the changes to a commodity price to evaluate overbought or oversold conditions. The RSI is an oscillator that can read from 0 to 100. Levels below 30 are considered oversold, while levels on the RSI above 70 are considered overbought.

The Bottom Line

Commodities are items used to power your car and build your home. Commodities are also in the foods we eat and the products we drink. The best commodities to trade are the ones that are the most liquid and fit within your trading style.

There are several platforms and products available that can facilitate commodity trading. Most investors are more likely to trade financial commodities than physical commodities. Physical commodity trading requires access to storage facilities, transportation, and large volumes of capital. The most popular types of securities for trading commodities include CFDs, futures contracts, and ETFs. There are also several types of trading strategies that you can use to trade commodities. The most popular research includes fundamental and technical analysis. Before pulling the trigger on a commodity trade, ensure you find the security and platform that fits your trading style.

(Above mentioned article is consumer connect initiative. This article is a paid publication and does not have journalistic/editorial involvement of IDPL, and IDPL claims no responsibility whatsoever)

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