commodity trading

Thinking about how commodity trading works

A commodity is a general product which can be bought and sold. A supermarket brand bottle of cooking oil is an individual item, not a commodity. On the other hand, a barrel of oil is a commodity because it is essentially the same no matter who produces it. Fuel is often traded as a bulk commodity.

There are four main kinds of commodities:

  • Energy
  • Livestock and meat
  • Agricultural
  • Metals

The futures market

The futures market enables a trader to buy a certain quantity of commodities at an agreed cost, to be delivered at a future date. Commercial organisations use the futures market to try and hedge their bets. For instance, if an airline company buys fuel when the price is low on the futures market, it means they can plan their costs ahead of time.
The buying and selling of commodities is one of the keys to maintaining stable global economics. Because of that, futures trading is always carefully regulated via organised exchanges.

Going for gold

Hang on to that gold ring or watch! Gold has long been used as an investment to hedge against inflation because it is viewed as a reliable commodity which holds its value.

Terminating a commodities contract

Surprisingly, paying for and delivering commodities accounts for just 1% of contract termination. Most commodity contracts end due to a range of other settlements. A counterparty may offer the difference in expected value, for instance, or both parties might make a reverse trade. The finer details of how commodities trading works can be complex.

What to look out for

Commodities are often affected by events which are impossible to predict. Unusual weather may impact harvests and cause a rise in prices; an earthquake might impact on oil production; a sudden drop in manufacturing demand may reduce the need for a specific precious metal, and a fall in its price. Some commentators say that investors should never allocate more than 10% of their portfolio to commodities due to these types of unpredictable risks. Other individuals feel they have a particular insight which justifies them investing more in the hope of making big profits.

So why invest in commodities?

If you are careful and well-informed, investing in commodities, which are actual assets, can be a better way to hedge your bets against the rises and falls of inflation. Commodities can also sometimes provide a more diversified equity risk (the amount of money you stand to make or lose).

Is it a gamble?

Even professional traders sometimes make unwise decisions. When this happens, commodities trading can become more like a gamble than a considered way to save money, and this is worth remembering if you are considering making a personal investment. However, if you seek professional guidance and stay informed, the commodity market can help you hedge your bets. For the brave investor with money to spare, volatile commodities markets can be an exciting place to take a chance and make cash.

Written by Wendy Davey

Copyright Io4 UK Limited

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