5 Reasons to Trade in Commodities
Over the past decade, the common person’s perception regarding investing has evolved considerably. While many people thought that equity investments were nothing more than a gamble, today, many investors are exploring new markets like commodities in addition to active equity investing. Commodities is one of the most popular asset classes and carries unique advantages, like a negative correlation with the stock market.
This blog will discuss the meaning of commodity trading, types of commodities, things to know before investing and reasons to trade in commodities.
Also Read: Why Do Stock Prices Fluctuate?
What Is Commodity Trading?
It is vital to learn the meaning of commodities and commodity trading. Commodities are the physical resources and raw materials that are used in the production of usable goods. All movable goods with an intrinsic value apart from money can be termed commodities.
The commodity market primarily includes two types of commodities. These include both hard and soft commodities. Here is a description of them.
- Hard Commodities:These are the raw materials used to manufacture more refined products. Examples include metals and fibre, which are used for further manufacturing.
- Soft Commodities: On the other hand, soft commodities are meant for immediate use. Examples include food products such as barley and sugar, used to consume and manufacture byproducts.
Commodity trading happens in the spot markets or exchanges. People can trade physical commodities via the spot market or derivatives such as futures or options. With derivatives, it is possible to trade them at the current or future date, and the prices are based on the basic economic rules of supply and demand.
This trade differs from traditional securities such as equities or bonds and offers additional portfolio diversification.
Commodity prices usually move opposite to stock prices. Hence, it is beneficial to leverage them amidst volatile market conditions. In addition to this, commodity trading has a lot of other benefits.
Types of Commodities Traded in the Market
Before learning about the reasons to participate in commodity trading, you will want to know what commodities you can trade. Given are some examples of highly traded commodities:
- Metals and Minerals: These include heavy-use metals such as copper, iron, aluminium, etc., and precious metals such as gold, silver, and platinum. During times of high market volatility, inflation, or currency devaluation, investors choose to invest in precious metals due to their reliability and conveyable value.
- Energy Products: Energy goods include gasoline, crude oil, natural gas, uranium, coal, etc., which are traded in bulk. The demand for such resources has recently surged due to various geopolitical issues.
However, one must also be aware that replacing these with alternative energy sources such as wind and solar may significantly impact the energy products market.
- Environmental Goods: This includes goods such as carbon credit certificates and renewable energy such as hydro, wind, solar energy, etc.
Also Read: How to Avoid Losses during Commodity Trading
- Agricultural Products: These include sugar, rice, cocoa, wheat, cotton, oilseeds, etc. The value of these types of products is volatile since they are season dependent. One can profit from them by taking advantage of lucrative supply-demand dynamics (when present).
- Livestock and Meat: This includes feeder cattle, live cattle, pork bellies, etc.
Some of the most traded commodities include bullion, gold, silver, and crude oil. Apart from these, cotton, corn, and wheat are also actively traded.
Reasons to Trade in Commodities
The following are the top 5 reasons why you may consider trading in commodities:
- A Simplified Trading Experience
One of the most significant reasons why commodity trading is on the rise is its simple process. Previously, trading used to be a tedious process, and opening trading accounts took as much time as three weeks. Nowadays, it is easy to trade from the comfort of one’s house, and technological advancements have reduced the account opening time to a few hours.
There are also rule-based investment engines that are AI-powered ,these enable investors to make informed trading choices. Commodity trading is viewed to be intuitively more comforting than stocks since their returns depend mostly on supply and demand.
- Provides Diversification
Portfolio diversification is an essential concept in trading and investing. It helps balance out the overall risk associated with your portfolio. When one asset class underperforms, its negative impact is offset by an asset class that performs well.
One of the top reasons to trade in commodities is portfolio diversification. Investing 15-20% of your total assets in commodities is recommended by some experts.
Commodities have a negative correlation with the equity market. When commodity prices rise, their production costs increase , and companies make less profit. Hence, the price of company stocks’ drop consequentially.
When inflation is stable, stocks perform well. On the other hand, commodities fare well during periods of rising inflation. As a result, the two are viewed to have a negative correlation.
- Hedging against Inflation
As discussed, commodities are an asset class that perform well against inflation. Gold bullion thus acts as a hedge for investors during high inflation or low interest rate environments.
Due to the negative correlation between stock and commodity performance, commodities are used to protect investors’ portfolios from inflation. This is one of the best reasons to trade in commodities.
- High Leverage Facility
Commodity derivatives such as futures contracts provide a high-leverage facility where traders can take buying and selling positions by paying an initial margin. By paying only 10% of the total contract amount, investors can hold the asset of a greater value.
For instance, suppose the price of gold is ₹54,000 for 10 grams. Then, if you would like to purchase 1 kg of gold upfront from the spot market, you would need to pay the whole amount. However, when you purchase a futures contract, you only need to pay 10% of the original value, i.e., ₹5,40,000, to buy the position worth ₹54,00,000.
Hence, a major advantage of commodity trading is owning a higher-value asset for a fraction of its actual value.
- Increased banking options
These days, many banks are taking broad exposure to the commodity market. Regulatory institutions have taken significant measures to protect the interests of investors and modernise trading platforms.
This has encouraged banks to expand their coverage and investors to choose commodity investments.
Things to Know before Trading in Commodities
The prices of commodities depend on numerous socio-economic factors such as GDP, inflation, international trade, interest rates, money market movements, etc. Apart from the above reasons to trade in commodities, one must also consider a few criteria before trading.
The following are some of these criteria.
- Understanding the Market Cycle
The market cycle of a commodity’s price depends upon various geopolitical and socio-economic factors. As an investor, it is vital to keep track and be up to date with such trends to make profits out of commodity trading. Experienced investors can track these market cycles quite well and time their investments accordingly.
- Selecting Popular Commodities with High Volume
Selecting commodities based on popularity is quite common. Precious metals, energy, and agriculture are some of the majorly traded commodities. Checking the trading volume of a commodity is essential since this shows the supply-demand for that particular commodity on a specific day. High-volume commodities are the ones that often offer significant gains.
- Avoiding Volatile Commodities
There are many advantages to trading commodities. However, you will want to avoid those with highly volatile prices. As the trades are based on future speculations, the importance of sufficient analysis cannot be understated. A commodity showing bullish patterns for a significant time may not be a good choice if it is likely to crash. Even though the returns can be high, the risk is also high.
- Analysing Your Risk Profile
Trading involves a certain amount of risk. Therefore, it is prudent for an investor to assess his/her risk tolerance before trading. If you have a low-risk tolerance, avoid high-risk commodity trades. Commodity trading is suitable for those with a high-risk tolerance and the corresponding return potential is also consequentially high.
- Selecting the Best Broker
The broker plays a significant role in commodity trading. That is why you will want to select a broker who uses the latest technology. It is also vital for the broker to have risk management abilities, research capabilities, and knowledge of demand-supply chains and economics.
Also Read: Trading in Commodity Oil: A Beginner’s Guide
The interest in commodity trading is growing in India. The primary reasons to trade in commodities have been listed above, along with ad hoc things to keep in mind. Commodities are an asset class that offers numerous investment options and unique benefits. However, it is important to know the risks of trading in commodities to avoid major losses.
Frequently Asked Questions
- How is the commodity market regulated in India?
While the Security Exchanges Board of India (SEBI) regulates the stock market, the Forward Markets Commission (FMC) regulates the commodities market. In 2015, FMC merged with SEBI, and since then, SEBI has regulated all trades in the capital market.
- Are there any disadvantages associated with commodity trading?
One of the significant disadvantages of commodity trading is this type of asset class is highly volatile due to the dependency on supply and demand. As a result, a supply chain crisis or a geopolitical event can adversely affect the prices of commodities, putting investors’ money at risk.
- What is the safety level of commodity trading?
Due to its speculative nature, investments in commodities always carry a high level of risk. There is heavy participation from speculators in the Indian commodities market, and thus, prices can fluctuate considerably. The commodities market is very volatile, and situations like a pandemic or a war can create significant imbalances.
- Which exchanges in India trade commodities?
There are two main commodity trading markets in India. They are Multi Commodity Exchange of India Ltd., Mumbai (MCX) and National Commodity and Derivative Exchange, Mumbai (NCDEX).
- How can one start commodity trading?
To start trading in commodities, one must first have a trading account with a certified brokerage firm. After that, the investor should consult their firm and make investment decisions wisely.