A Beginner's Guide to Soft Commodities Trading

What are Soft Commodities?

Soft commodities, also known as "softs," refer to a group of raw, agricultural products that are grown, rather than extracted or mined, and are typically used for human or animal consumption. Unlike hard commodities such as metals or energy products, soft commodities have a limited shelf life and are highly sensitive to environmental factors, such as climate and weather conditions.

Examples of soft commodities include coffee, cocoa, sugar, corn, wheat, soybeans, cotton, and livestock, among others. These commodities are traded on various global exchanges, like the Chicago Board of Trade (CBOT), the New York Mercantile Exchange (NYMEX), and the Intercontinental Exchange (ICE). Market participants range from farmers and producers, who use the markets to hedge their risk, to investors and speculators, who aim to profit from price fluctuations.

Soft commodities play a crucial role in the global economy, as they serve as the basis for the production of numerous goods, including food products, textiles, and biofuels. The prices of soft commodities are influenced by various factors, such as supply and demand dynamics, global economic conditions, geopolitical events, and weather patterns. These factors, in turn, can have a direct impact on consumer prices and the broader economy.

Soft commodities are vital agricultural products that form the backbone of the global economy, contributing significantly to the sustenance and well-being of human and animal life. As a trader or investor, understanding the unique characteristics and factors that influence the prices of soft commodities can provide valuable insights and potential opportunities in this dynamic market sector.

The Soft Commodities Market

The soft commodities market is a vibrant and essential part of the global trading ecosystem. It encompasses a diverse range of agricultural products and provides a platform for various market participants to buy, sell, and hedge their positions. This market facilitates the trade of soft commodities through standardised contracts known as futures and options, which are designed to help manage price risks and enable price discovery.

Futures contracts are agreements to buy or sell a specific quantity of a commodity at a predetermined price and date in the future. These contracts are traded on regulated exchanges, such as the Chicago Board of Trade (CBOT), the New York Mercantile Exchange (NYMEX), and the Intercontinental Exchange (ICE). Options contracts, on the other hand, give the buyer the right, but not the obligation, to buy or sell a commodity at a specific price within a specified time frame.

Aside from futures and options, soft commodities are also traded in the form of CFDs. CFDs provide a simpler approach to trading soft commodities and other products with features such as flexible position sizing, no expiry dates, and no ownership of the underlying products.

Pepperstone offers CFDs on soft commodities and a range of other assets through highly competitive conditions and with multiple platform options.

The soft commodities market operates through a bid-ask system, where buyers and sellers place orders at specific prices. This process helps establish the current market price for each commodity, ensuring transparency and fair pricing. In addition to market participants like farmers, producers, and end-users, the soft commodities market also attracts investors and speculators who seek to benefit from price fluctuations.

Trading in the soft commodities market is primarily driven by factors such as supply and demand, weather conditions, geopolitical events, and global economic conditions. Market participants must stay informed about these factors to make well-informed trading decisions. Additionally, understanding the mechanics of futures and options contracts can help traders navigate the intricacies of the soft commodities market and capitalise on potential opportunities.

Factors Affecting Soft Commodities Prices

Understanding the factors that influence the prices of soft commodities is essential for making informed trading decisions. Here are some key factors to consider:

Climate and Weather

The production of agricultural commodities is highly dependent on favourable weather conditions. Unpredictable climate events, such as droughts, floods, and storms, can significantly impact crop yields, leading to price fluctuations as supply is affected.

However, thanks to the rapid advancements in technology and the continuous improvement of forecasting methods, those involved in trading soft commodities now have access to faster, better, and more accurate information than ever before.

This enhanced capability to predict short-term weather and assess climate patterns helps mitigate some of the uncertainties inherent in the soft commodities market, enabling traders to make more informed decisions.

Government Policies and Regulations

Government interventions, such as subsidies, tariffs, import/export restrictions, and biofuel mandates, can directly impact the supply and demand dynamics of soft commodities. Additionally, changes in agricultural policies can influence farming practices and crop choices, affecting market prices.

Supply and Demand

The balance between supply and demand is a primary driver of soft commodities prices. Factors such as population growth, changing dietary habits, and economic development can impact demand for these commodities. On the supply side, advancements in agricultural technology, crop yields, and farming practices can influence production levels.

Geopolitical Events

Political instability, conflicts, and trade disputes can disrupt the global flow of soft commodities, creating supply chain uncertainties and impacting prices. Such events can also lead to policy changes that affect trade and production.

Currency Exchange Rates

Since soft commodities are traded on international markets, fluctuations in currency exchange rates can impact their prices. A stronger US dollar, for instance, makes commodities more expensive for buyers using other currencies, potentially reducing demand and leading to lower prices.

Staying informed about these factors and monitoring market developments can help traders better understand the dynamics of the soft commodities market and make more informed decisions when trading these products.

Getting Started with Soft Commodities Trading

Embarking on your soft commodities trading journey involves several key steps to ensure a solid foundation. Here are some essential aspects to consider:

Choosing a Broker

It's crucial to choose the right broker that meets all the requirements of an ideal trading partner. At Pepperstone we offer a seamless trading experience by providing access to global soft commodities markets, competitive fees, advanced trading platforms, robust customer support, and strong regulatory compliance.

By choosing Pepperstone you can ensure a solid foundation for your trading success and gain the necessary tools to navigate the dynamic world of soft commodities and a range of other assets.

Types of Soft Commodities Trading

There are various ways to participate in the soft commodities market, including trading futures and options, investing in Exchange-Traded Funds (ETFs) that track soft commodity indices, trading Contract for Differences (CFDs) on underlying commodities, or purchasing stocks of companies involved in the production, processing, or distribution of soft commodities.

CFDs allow you to speculate on price movements of soft commodities without owning the physical asset, providing flexibility and the ability to benefit from both rising and falling markets. However, although there is the opportunity for profit, it’s important to keep in mind that there is also the risk of loss.

Assess your risk tolerance, investment goals, and trading preferences to determine the most suitable approach for engaging with the soft commodities market.

Risks and Benefits

Soft commodities trading offers numerous benefits, such as portfolio diversification, hedging against inflation, and the potential for attractive returns. However, it also carries inherent risks, including price volatility, unpredictable weather events, geopolitical uncertainties, and currency fluctuations. Developing a well-researched trading strategy, setting risk management guidelines, and staying informed about market developments could help mitigate these risks.

Soft Commodities Trading Strategies

Developing an effective trading strategy is essential for success in the soft commodities market. Here are some key components to consider when crafting your approach:

Fundamental Analysis

This involves examining factors that directly impact the supply and demand dynamics of soft commodities, such as weather conditions, crop reports, government policies, and global economic data. By understanding these factors, traders can anticipate potential price movements and make informed decisions.

Technical Analysis

This approach focuses on analysing historical price data and chart patterns to identify trends and potential market turning points. Technical indicators, such as moving averages, oscillators, and support/resistance levels, can help traders gauge market sentiment and establish entry and exit points for their trades.

Combining Fundamental and Technical Approaches

While some traders may have a preference for using only one type of analysis, incorporating both technical and fundamental approaches can offer a more comprehensive understanding of the markets. Being aware of current fundamental developments is important even for devoted technical analysts. This broader set of tools can lead to more informed decisions.

Trading Styles

There are various trading styles suited to different risk profiles and time horizons, including day trading, swing trading, and position trading. Day trading involves opening and closing positions within a single trading day, while swing trading typically involves holding positions for several days or weeks. Position trading is a longer-term approach, where traders hold positions for weeks, months, or even years. Assess your risk tolerance, time commitment, and trading goals to determine the most appropriate style for you.

Risk Management

Establishing sound risk management practices is crucial for long-term success in soft commodities trading. Set stop-loss orders to limit potential losses, maintain a diversified portfolio to spread risk, and employ proper position sizing to avoid overexposure to a single trade.

A well-rounded soft commodities trading strategy should incorporate fundamental and technical analysis, adopt a suitable trading style, and prioritise risk management. By refining and adapting your strategy over time, you can potentially increase your chances of success in the ever-changing soft commodities market.

Soft Commodities Trading Examples

Example 1: Coffee

For those who are new to soft commodities, the first product that comes to mind is none other than a very popular and consumed beverage on a daily basis: Coffee. Let’s take a look at an example of a trade on coffee:

Let’s say you’ve been watching the charts for a while and believe that the price of coffee is set to rise over the coming days, supported by positive fundamentals.

You go on the trading platform, open the trade window for coffee and buy 1 CFD of coffee at 194.00.

Your target is 200 and you place a stop loss at 189.

The contract size of coffee at Pepperstone is 10,000 lbs so a $1 move in the price of coffee is worth $10.

Let’s say that you were right and the price of coffee rose to 198. Right now, your current PnL is:

(198 (current price) - 194 (entry price)) x $10 = $40.

You can choose to exit the trade for a $40 profit or continue to hold the position.

Just like coffee, Pepperstone offers a wide range of soft commodities that have standard sizes but allows for flexible position sizing which makes it easy for small and large traders to participate in such markets through CFDs.

Example 2: Corn

Corn has been trending lower for a while, pushed by negative fundamentals. You decide to go short, as you expect the prices to continue lower for some time.

You decide to sell 1 CFD of corn at 6.3463 with a target of 6.0000.

1 CFD of corn at Pepperstone is equal to 100 bushels so a $1 move in the price of corn is worth $100.

Let’s say the price of corn drops further, quickly reaching your target. With a take profit order in place, your position is closed for a profit.

In order to calculate your profit, we do the following:

(6.3463 (open price) - 6.0000 (current price)) x 100 = $34.63.

Conclusion

Soft commodities trading can be beneficial for those who take the time to understand the market and trade wisely.

This beginner's guide provides an overview of soft commodities trading, including what soft commodities are, how the market works, factors affecting prices, and tips for successful trading. Remember to conduct your research, choose a reputable broker, and employ sound trading strategies.