Trading other instruments

Commodities are the building blocks of the global economy. They're the raw materials for millions of products manufactured around the globe. Commodity markets and their supply chains create highly active markets that present many opportunities to traders.

Let’s take a look at the role of commodities and how we can trade them.

We can define a commodity as a raw material or primary product that is freely bought and sold, and we also use the word to imply that something is readily available and unbranded.

Effects of the US dollar

The US dollar is the world’s reserve currency and the native currency of our biggest economy. As a result, most commodities are priced and traded in US dollars. Historically, a strong dollar has depressed the price of commodities whereas a weaker dollar often results in a commodity prices rise. We can see this relationship in the chart below, which plots the trade-weighted US dollar or dollar index against the CRB index (tracks a basket of widely-used commodities).

As the dollar, drawn in green, appreciated the basket of commodities, the blue line, fell in value.

Other key drivers of commodity prices.

Emerging markets

Many of the largest deposits or growing areas for commodities are found in the developing or emerging markets. Countries such as Brazil, Chile, Nigeria, South Africa and Saudi Arabia are all examples of regions that play a major role in their supply. The price and level of demand for their commodities directly influence the performance of local economies and their currencies.

Supply and demand

The balance between supply and demand is the largest influence on commodity prices. When supplies are plentiful and rising, prices will typically fall until they attract fresh demand into the market. When demand’s high and can't be met by the existing supply, commodity prices will rise until the point where new supplies are drawn into the market. Unlike financial products, fresh supplies of commodities may not be available immediately, and the timeline for their production and transmission can extend over many months. This means that commodity prices can undergo large price movements from time to time.

Production halts

Many commodities are mined or extracted from the earth, a process that relies on large labour forces. Mining companies try to keep their cost of extraction as low as possible, and keeping wages down is one way to do this. Employers and trade unions don't always agree, and this dissent can lead to labour unrest, strikes and production halts. The prices of metals such as copper, platinum and palladium are all sensitive to labour unrest and possible interruptions to supply.

Seasonality

Agricultural commodities are often subject to seasonality. Crops are grown and harvested in a specific cycle, and there'll be periods of the year when they're in surplus and other times when they're relatively scarce. However, there are also seasonal factors in non-agricultural commodities, such as gold, which sees increased demand from buyers in India and China during important holidays and the wedding season.

Weather

Closely related to seasonality, the weather can affect commodity prices. These effects are usually associated with foodstuffs and agricultural commodities. For example, if there's a frost in Florida, it can reduce the size of the orange harvest and raise the price of orange juice. Drought, high winds, excessive rain, flooding and pestilence can damage a crop or harvest, limiting supply and driving up prices. Weather patterns can also be beneficial leading to bumper harvests and excess supplies of a commodity, which can then depress prices as buyers aren't incentivised to pay up for that product.

Excess demand

From time to time, the demand or expected demand for a particular commodity can quickly outstrip the available supply. For example, US natural gas prices can spike if temperatures drop, or are expected to drop below seasonal norms in the USA. If that happens, energy companies move to secure gas supplies and find themselves in competition with their rivals as well as other traders and speculators, who are attracted into the market by the upward price momentum. This can cause prices to be squeezed higher.

We saw this type of spike in November 2018 on the natural gas chart below. The spike was relatively short-lived and was unwinding by early December.

However, that price action shows that even in a market as liquid as natural gas, an interruption to supply or an expectation of outsize demand can affect commodity prices. Energy markets are also linked to geopolitics, examples of this include US sanctions against Iran and Russia that directly target their ability to export oil and other goods, while trade bodies such as OPEC often try to restrict production to pre-agreed levels.

Large economies

During the last thirty years, the world's economies have become globalised. Many developed economies moved towards services and away from manufacturing, much of which was offshored in the low-cost centres of Asia. The beneficiary of this global trend was China, which quickly became the largest importer of commodities in the world. The trends in China's economy are an increasing influence on commodity prices.

According to data from the Harvard Atlas of Economic Complexity, China imported US$49.3bn of iron ore, US$19.7bn worth of copper ores and US$109bn worth of crude oil and petroleum products during 2016. These are just three examples that show the scale of demand for commodities within the Chinese economy.

Growth expectations for China and its economy have a direct bearing on the outlook for many commodity prices. At the time of writing, those expectations are heading lower, which we can see in the above chart of China’s GDP growth.

What you need to know before trading commodities

To trade commodities successfully we need to get to know the underlying markets, find out who are the big producers and who are the big consumers of a particular commodity, and understand how those commodities get from A to B.

It's also worth understanding which products the underlying commodities are used in, for example, copper is associated with construction and electronics, sugar with confectionery and food manufacturing.

Don't forget, commodities tend to trend. When those trends break, commodity prices can undergo sharp reversals. It’s important to be alert to any price action and news flow that suggests a change may be on its way and be sensible with the use of stop losses and money management around your open positions.

How to trade gold

Gold isn't just a commodity, it's a store of wealth and a form of money in itself. Gold is scarce and widely recognised around the world for its value. It's this scarcity and global worth that investors buy in times of economic and political crisis, or when they see threats to the value of paper money from either inflation or currency printing.

It's not only individual traders and investors who own gold. Many of the world's central banks hold thousands of metric tonnes of it. The central banks use gold as a store of value and a form of money to diversify their strategic reserves away from international currencies because gold is often seen as being uncorrelated to many other asset classes.

Gold is mined from the earth and as such is traded as a commodity. Like most commodities, it's priced in US dollars, and because of its scarcity, gold is traded in what's known as troy ounces, the equivalent of 31.21 grams. A kilo of gold represents just over 32 troy ounces.

Various factors influence the price of gold, including:

• The US dollar - Historically a strong US dollar has depressed the price of gold whereas a weaker US dollar has often meant that gold prices rise.
• Economic, political and financial factors - Beyond its relationship with the US currency, gold prices are influenced by economic downturns, political crisis, war and trade tensions, as well as the levels of, and trends in global inflation.
• Volatile outlooks - As a rule of thumb, the more volatile the geopolitical or economic outlook is, then the higher the price of gold is likely to be. When markets are calm, major economies are performing well and there are few international tensions, then the price of gold tends to drift lower.
• Supply and demand - Gold prices are also influenced by supply and demand. Supplies are limited, and demand often fluctuates around Indian and Chinese buying of gold as gifts, during their wedding and holiday seasons.
• Production - Strikes and halts in production in countries such as Australia and South Africa can also drive gold prices higher.
• Industry-related demand - There are also a growing number of uses for gold in industry, often in high tech electronics and medicine.

The price of gold is driven by a wide variety of factors many of them independent of each other, as such the gold price is rarely static which makes it an ideal instrument for traders. Considering adding gold to your trading portfolio? Find out more.