What is commodity trading and how do you trade them?

What is commodity trading?

Commodities are the lifeblood of our economies; they are integral to our infrastructure, our communications, energy and power, food, clothing, and much more. As such commodity markets are an essential part of modern life.

They are traded by producers, consumers and end users, speculative traders and investors, around the world.

Nearly all commodity contracts (the name given to the standardised units in which commodities trade) are deliverable.

That is, the buyer must be able to take delivery of the underlying commodity, at the conclusion of the contract, and the seller must be able to make that delivery.

However, in practice, it’s usually only commercial traders and end users who take delivery of the underlying commodity. Speculators typically trade out of their positions or roll them forward well before delivery is due.

Most retail traders trade commodities using non-deliverable, cash-settled CFDs (Contracts for Difference).

Why do people trade commodities?

Commodity prices fluctuate based on factors, such as supply and demand, geopolitics, the weather, the strength or weakness of key currencies, and macroeconomic data.

Those price movements can be sharp and sustained, which makes commodity trading an attractive proposition for speculators, however, it is not without its risks.

How do you trade commodities?

To start trading CFDs on commodities there are just a few simple steps you need to take:

1. You’ll need to open an account with a broker, such as Pepperstone, who will provide you with a choice of trading platforms, and access to CFD commodity prices.
2. Once your trading account is open you can fund it by making a deposit.
3. The next step will be to download the trading platform and then you can familiarise yourself with how it works.
4. Once you are confident about using the trading platform you will be ready to start trading commodity CFDs.
5. Pepperstone trades in what are known as commodity CFDs, or Contracts For Differences, which are cash-settled and non-deliverable.
6. That means you can trade long or short with equal ease, and don't have to worry about the ownership or delivery of the underlying commodities.

What are the different types of commodities?

Commodities can be divided into two main groups, known as hard and soft.

Hard commodities include things like copper, nickel, gold, oil and gas, and other industrial materials.

Whilst the soft commodities include foodstuffs and ingredients, such as cocoa, coffee, wheat, corn, and soya. As well as cotton, lumber and livestock.

What are the benefits in trading commodities?

Dealing in commodities allows you to diversify your trading away from equities and FX and into these largely uncorrelated markets.

Trading commodities means you can take a view on the global economy, geopolitics, and demand.

At a macro or top-down level.

That’s because commodity prices are often the first to react to breaking news and world events.

What are the risks in trading commodities?

More than any other markets, commodity prices are driven by supply and demand. The deliverable nature of the underlying contracts means commodity prices can be extremely volatile.

For example, between April 2023 and April 2024, cocoa prices rallied by +285.0%, according to data from Trading Economics. Commodities can be subject to short squeezes or extreme oversupply, each having a direct and immediate effect on prices.

A notable example is the price of European Natural Gas (TTF), which jumped by more than +400.0% between June and mid-August 2022 due to global gas supply constraints following Russia’s invasion of Ukraine.

Leveraged contracts, such as commodity CFDs, are powerful tools for traders but can magnify losses as easily as they can profit if not used correctly.

What factors influence commodity prices?

Commodity prices are influenced by a wide variety of factors.

However, two of the most influential of these are geopolitics and seasonality.

Geopolitical events can rapidly alter the supply and demand dynamics of commodities, as demonstrated by the Russian invasion of Ukraine, which directly affected the price of oil and gas.

The conflict in Gaza has deterred many major shipping lines from accessing the Suez Canal, driving up the cost of transporting commodities from the Asia-Pacific region to end markets in Europe.

Seasonal factors such as the weather can directly affect the price of agricultural commodities and foodstuffs.

Cold snaps, heatwaves, too little, or too much rain, can all hamper crop production, crop yields and harvests.

Disease and pestilence are other seasonal factors that can create volatility in soft commodity prices, especially those of crops and livestock.

How important is diversification in commodity trading?

Diversification is one of the main attractions of commodity trading because commodities such as gold move independently of equity and bond markets.

Traders and money managers will often add precious metals and other commodities to their portfolios for this very reason.

Traditionally gold is seen as a store of value and hedge against inflation, as such it acts as a safe haven in times of crisis.

What is margin trading and how does it work in commodities?

Margin trading allows you to take larger positions in the commodity markets than your account balance would otherwise permit. In margin trading, your broker leverages the money in your trading account.

For example, if you have $500 in your account and you trade a commodity with 10-times leverage offered by your broker, you could control a position worth up to $5,000, which is 10 times the value of your $500 account balance.

To achieve this leverage, your broker effectively lends you the difference between your initial margin or deposit and the notional value of your trade.

To open and maintain a margin trading position, you will need the funds to meet the initial deposit requirement, as well as additional funds to cover any running losses or variation margin in the position while it's open. If you do not have sufficient funds in your account to cover any running losses on your open positions, you will face a margin call and could be closed out.

This is why correct position sizing and having the right number of positions open relative to your account size is crucial in margin trading.

If you keep a trade open overnight, you will incur funding or interest charges on the notional value of the trade. However, depending on when the charges are applied, there may be no funding charges on trades that are opened and closed on the same business day.

Please note that margin or leverage rates vary between products and regulatory jurisdictions.

How do I effectively use leverage in commodity trading?

You can use the leverage available in commodity trading to increase your exposure to the markets and to create heightened returns from your profitable trades.

For example, a +10.0% move on a leveraged position worth $5,000 would result in a P&L swing of $500. Whereas, the same move in an unleveraged position of $500 notional would create a P&L swing of just $50.

Conversely, a -10.0% move in a leveraged long position with a notional value of $5,000 would result in a P&L swing of -$500. However, the same move in an unleveraged position of $500 notional would create a P&L swing of just -$50.

Leverage in commodity trading should be used sparingly; you should not overtrade by, for example, leveraging your entire account balance on one trade.

To use leverage successfully, you need to have a disciplined approach to risk and reward, money management, and trade sizing.

What are some common strategies for trading commodities?

Commodities are largely priced in US dollars, and the strength or weakness of the dollar directly affects the value of commodities. A stronger US dollar tends to depress prices, while a weaker US dollar can lift commodity prices. Traders can take advantage of this relationship by selling commodities when the dollar is strong and buying commodities when the dollar weakens. However, it is important to note that there are other factors that can affect the pricing of commodities, such as supply and demand dynamics, geopolitical events, and economic indicators.

Traders also often buy or sell gold based on the mood of the stock and bond markets. If equity traders are feeling “Risk-Off,” they are likely to sell stocks and buy safe havens, such as precious metals, theoretically pushing their prices higher. Conversely, if markets are in a “Risk-On” mood, traders will be selling safe havens and jumping back into riskier assets like stocks, and against that background, gold prices are likely to fall.

While these are common strategies, there are always additional factors that can influence the price of commodities, making it crucial for traders to stay informed and consider a wide range of variables in their decision-making process.

How do I manage commodity trading risk more effectively?

To manage your commodity trading risk more effectively you need to follow some simple rules:

• Don’t over-trade
• Consider using a stop loss and think about where you place your stop.
• And remember that all commodity prices can be affected by movements in the value of the US dollar and often by major macroeconomic data releases.

What role does sentiment analysis play in commodity trading?

Sentiment analysis can play an important role in commodity trading. However, unlike other markets that focus on analysing social media posts and commentary, commodity traders primarily rely on positioning reports to gauge market sentiment.

The most important of these, the Commitment of Traders or CoT report, is published each Friday by the US CFTC or Commodity Futures Trading Commission.

The report provides a breakdown of the open positions in US futures markets held by specific groups of traders, as of the close of business, on the previous Tuesday.

Changes in those positions can shed light on what large speculators or commercial commodity traders think about commodity markets and may help to identify emerging trends within those markets.