What Are Commodities? : The Ultimate Guide for Beginners
Commodities play an essential yet often mysterious role in powering the global economic engine. These raw materials – which include crude oil, precious metals, agricultural goods, and livestock – are consumed in vast quantities to meet energy, manufacturing, and basic survival needs.
But unlike company stocks, commodities don’t come with balance sheets or PE ratios to consult for guidance. Instead, multifaceted supply/demand dynamics spanning from Southern U.S. cotton farms to Chinese metals factories to Saudi Arabian oil fields collectively set global benchmark commodity prices in real-time.
Newcomers to the complex world of commodities investing face daunting technical hurdles and informational asymmetries compared to veteran traders. But by methodically building baseline levels of market knowledge, newbies can gain a fighting chance of generating compelling risk-adjusted returns.
Key Takeaways
- Commodities like oil, metals, and agricultural products are vital raw materials powering the global economy
- Prices fluctuate based on unpredictable supply and demand dynamics spanning weather, geopolitics, economic shifts, and more
- Commodities can diversify portfolios, especially amid high inflation where stocks and bonds struggle
- Myriad trading approaches exist including futures, ETFs, spread betting, and options contracts
- Success requires continuous learning about commodity fundamentals and prudent risk management given the volatility
What Are Commodities and Why Do They Matter?
Commodities encompass a broad range of raw materials used to produce, package, and transport commercial and consumer goods across the global economy.
The earliest commodities dating back millennia included salt, silk, spices, gold, silver, metals, livestock, and grains. Many still actively trade today.
In modern times, new commodities have emerged including crude oil, natural gas, uranium, carbon credit offsets, bandwidth rights, rare earth metals, and cryptocurrencies.
Common through the ages are certain essential characteristics that qualify resources as tradable commodities:
- Fungibility (standardization)
- Deliverability (ease of transfer/storage)
- Liquid markets and price discovery mechanisms
Without commodities constantly flowing across borders unencumbered, the gears of globalization would cease driving progress and higher living standards.
Why Do Commodity Prices Fluctuate?
Commodity prices move based on the interplay between available supply (production, stockpiles) and global demand (consumption trends).
When supplies tighten or demand strengthens for a commodity, its prices typically appreciate. Conversely, oversupplies or falling demand prompt declines.
Myriad unpredictable factors continuously alter supply/demand balances – and by extension – real-time commodity valuations spanning:
On the supply side:
- Unforeseen weather events
- Geopolitical conflicts
- Technology innovations
- Energy/transport costs
- Environmental policies
- Inventory levels
On the demand side:
- Global economic growth patterns
- Income/demographic shifts
- Consumer preferences
- Government policies
- Market speculation
- Currency valuations
This endless complexity offers profit-seeking traders endless opportunities.
Let’s survey the main commodity groupings and the unique supply/demand dynamics driving each.
Types of Commodities
Commodities are generally classified by source into Energy, Metals, Meat/Livestock, Agricultural (grains, fibers), and Exotic/Rare categories.
| Category | Description | Examples |
|---|---|---|
| Energy | Raw materials used for power generation | Oil, natural gas, coal, uranium |
| Metals | Metals used across industries | Gold, copper, lithium, steel |
| Agriculture | Food and fibers | Corn, coffee, sugar, cotton |
| Livestock | Animal products | Cattle, hogs, dairy |
Energy Commodities
Oil stands unmatched as the world’s essential commodity with $33 trillion in annual transaction volume meeting 33% of total energy needs. Academic studies confirm oil price spikes preceded 10 of the 11 post-WWII recessions – demonstrating the unmatched power of black gold over economic cycles.
| Commodity | 2021 Production | Key Producers | Usage | Price Swings Factors |
|---|---|---|---|---|
| Oil | 95 million bpd | US, Saudi Arabia, Russia | Transportation fuels, plastics | Supply deficits, geopolitical conflicts |
| Natural Gas | 4 trillion cubic meters | US, Russia, Iran | Residential heating, electricity, cooking | Weather demand spikes, storage levels |
| Coal | 8 billion tonnes | China, India, Indonesia | Electricity generation, steel making | Environmental policies, alternatives |
Natural gas serves as the primary fuel for residential heating, cooking, industrial processes, and electricity generation. When early winter cold snaps strain gas stockpiles, prices historically spike higher.
Coal fires roughly 30% of the world’s electricity needs and remains a vital baseload power generation source despite decarbonization pressures. China, India, Australia, and Indonesia serve as major export hubs.
Uranium provides raw nuclear fuel driving 10% of world electricity with demand growth expected from 50 new plants underway globally. Top producers include Kazakhstan, Australia, and Canada.
Metal Commodities
Gold reigns as the quintessential safe haven asset with 46% of demand coming from global investors in coins, bars, ETFs, and bullion. Central bank purchases reached decade highs in Q3’2021. Both inflation fears and economic uncertainties underscore the valuation upside.
Copper serves as the backbone of electrifying global decarbonization initiatives. With 63% of output used in construction wiring and electronics, surging demand stretches supplies thin.
Lithium brings electric vehicles to life as a key battery component. The White House projects US lithium battery demand to grow by ~400% in coming years underscoring massive supply strains that emerging producers rush to alleviate.
Agricultural Commodities
Corn stands as the top-produced feed grain with half the US harvest feeding livestock animals to produce poultry, milk, eggs, and meat. Prices closely track crude oil values since corn serves as the key US ethanol biofuel feedstock mixed into gasoline supplies.
Coffee drinks boast over 2 billion daily consumers – making the caffeinated seeds one of the world’s favorite commodities. But shifting weather patterns and plant disease periodically strain global production capacity resulting in dramatic price spikes at the grocery store checkout when supplies tighten.
Sugar brings sweetness to global food supplies with 70% used in processed foods and beverages. Bad growing seasons and export quotas periodically whip global wholesale prices into volatility, sending shockwaves to consumer food budgets.
Cotton makes up 40% of the total fibers used in clothing thanks to its softness, breathability, and durability. Shopping mall seasons drive predictable consumer demand shifts. However, supply uncertainties from major exporters like China, India, Brazil, and the US frequently cause large price swings.
| Crop | 2022 Production | Top Producers | Price Sensitivity |
|---|---|---|---|
| Corn | 1.2 billion tonnes | USA, China, Brazil | Oil prices, ethanol demand |
| Coffee | 167.2 million bags | Brazil, Vietnam, Colombia | Weather patterns, supply deficits |
| Sugar | 173 million tonnes | Brazil, India, Thailand | Export quotas, food/beverage demand |
Exotic Commodities
More eclectic offerings also make their way to global trading platforms as investible commodities:
- Carbon credits: Payments to balance out greenhouse gas emissions priced $50+/credit
- Sand/gravel: Infrastructure construction inputs with black market pressures
- Palladium: Indispensable auto catalyst component seeing extreme deficits amid supply chain strains from the Russia/Ukraine war
- Lumber: Home building staple with volatile pandemic demand swings widely publicized
Hundreds of other goods also maintain futures contracts supporting active trading of underlying physical commodities – ranging from orange juice concentrate to platinum ingots to lean hog carcasses.
Why Commodities Matter for Portfolio Diversification
Commodities shine as an asset class demonstrating a low correlation to bonds and equities, making them powerful portfolio diversification tools.
While company stocks tend to strengthen during economic expansions and weaken during recessions, commodity dynamics differ greatly. Their physical scarcity and supply limitations help buffer against weakening growth periods.
For example, during rampant 1970s inflation, commodities trounced stocks and bonds delivering nearly 15% annualized returns compared to 2% losses for the S&P 500 index over that decade per Wells Fargo analysis.
While exceptions exist under unique economic conditions, commodities historically reward investors for shouldering their wide price oscillations.
Understanding Commodities Contract Specifications
Before trading, investors must comprehend the specifics of futures contracts covering:
- Grade/Quality: Minimum purity, consistency, characteristics
- Contract Size: Quantity of the commodity being transacted
- Price Limits: Boundaries restricting daily price movements to dampen volatility
- Last Trading Day: Final date when the contract trades before expiration
- Settlement: Process of physically delivering or cash-settling contracts
For example, the CME lumber futures contract represents random length boards with contract size = 110,000 board feet and tick size = $10/1000 board feet.
Getting comfortable with these logistics helps newcomers avoid costly missteps.
Common Commodity Trading Approaches
Myriad options exist for capitalizing on commodity price swings:
- Futures contracts – Agree to buy/sell a commodity at a set price on the expiration date
- Options contracts – Lock in the right to buy/sell a commodity at a set price before the expiration
- Commodity stocks – Shares in commodity producers
- Commodity funds – Mutual/ETF funds tracking commodity futures indexes
- Spread betting – Wager on commodity price direction without direct ownership
- Contracts for difference – Agreements exchanging commodity price differences over time
Each approach carries unique risk/reward considerations.
| Approach | Description | Risk Level |
|---|---|---|
| Futures | Contracts giving the right to buy/sell | High |
| Options | Contracts giving right to buy/sell | High |
| Stocks | Company ownership shares | Varies |
| Funds | Mutual/ETFs tracking indexes | Varies |
Key Commodity Trading Strategies
Seasoned traders utilize varied approaches pinpointing ideal market entry and exit timing while accounting for product expiration impacts:
- Technical analysis – Using price/volume charts and indicators to identify support, resistance, trends and activity
- Seasonal spreads – Exploiting recurring supply/demand imbalances around annual events
- Carry trade arbitrage – Simultaneously buying and selling similar commodity contracts targeting temporary differentials
- Intramarket spreads – Holding long and short positions in multiple contract expirations of the same commodity
- Intermarket spreads – Holding long/short positions in different but related commodities
Getting comfortable with major commodity producers, consumers, import/export trends, and market data resources greatly eases navigating multifaceted global variables impacting prices.
12 Helpful Tips for New Commodity Traders
Follow these suggestions when first wading into commodity markets:
- Thoroughly research commodities and analytical techniques before starting trading
- Start small using stop losses and demo practice accounts to manage risk
- Remember that commodities, unlike company stocks, cannot go to zero value
- Closely track key market-moving news announcements, data releases, and geopolitical events
- Focus only on commodities where you grasp the core supply/demand dynamics
- Account for weather, seasonality, and production cycles influencing prices
- Optimize timing before expiration dates on futures contracts
- Concentrate on commodities demonstrating compelling technical chart patterns or advantageous seasonality trades
- Always examine contract rolls for potential convergence/divergence of front/back month contracts
- Avoid overweight concentration into single volatile contracts without diversifying
- Consider pairing with forex currencies that strengthen from rising commodity prices
- Engage in continuous learning as an evolving trader honing your edge
Arm yourself with baseline levels of commodity knowledge, risk capital you aren’t afraid to lose, and substantial patience helping to endure inevitable peaks and valleys. Over time, newbies can transform into consistently profitable traders.
Getting Started in Commodities Investing
Many brokers provide access to commodity futures trading along with complementary practice accounts.
Leading options include:
- TD Ameritrade – Trusted leader offering price-competitive margin rates, $0 trades, and thinkorswim mobile app
- E*Trade – Respected trading platform with $1.50/contract charges waived for 30+ monthly contracts
- Interactive Brokers – Sophisticated platform popular among active futures traders with discounted $.85/contract tiered pricing
- TradeStation – All-in-one broker tailored for technically focused commodity traders
Evaluate each broker’s strengths aligning best with your needs and skills as a unique trader.
Here is a continuation of the section on getting started in commodities investing from the suggestion of TradeStation:
- Marex – London-based independent broker specializing in metals, agriculture, and energy commodities, offering deep insights for institutional clients
- ADM Investor Services – Well-respected futures commission merchant part of Archer Daniels Midland providing retail and commercial client market access
- R.J. O’Brien – Independent futures broker with customized risk management solutions tailored for farmers, commercial hedgers, and active traders
- StoneX – Offers markets across equities, forex, commodities, futures, and clearing services with proprietary risk and execution analytics
Many other firms also operate introducing brokerage units that partner with guarantee clearing futures brokers to offer commodity trading.
Evaluate each platform carefully across criteria including available market access, technology capabilities, trading tools, insights/research, customer service reputation, and overall costs.
Optimal decisions depend greatly on your specific trading style, risk tolerance, background knowledge of commodities, capital position, analytical skills, and time availability to track evolving global market dynamics.
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While easily accessible online trading makes getting started temptingly easy, don’t underestimate the challenges novice commodity traders face competing against elite hedge funds, major institutions, and deeply knowledgeable veterans constantly angling for an edge.
But with rigorous self-education, prudent risk management discipline, continuous screen time tracking world events, and persisting through inevitable early setbacks, profitability awaits dedicated newcomers who evolve into savvy traders.
The journey won’t be easy. But the potential rewards make it eminently worthwhile. Over time, persistently building commodity knowledge and prudent risk management skills can help transform raw beginners into consistently profitable traders – joining the top ranks of global commodity specialists.
Commodities Trading FAQs
Below are answers to some frequently asked questions about getting started with commodities:
What factors affect commodity prices?
Major influences include supply/demand shifts, production costs, economic trends, geopolitical conflicts, weather, and investor speculation. Unpredictable changes in any of these dynamics can trigger large price swings.
How can I trade commodities?
Popular options involve futures contracts, commodity stocks/funds, spread betting, contracts for difference (CFDs), and exchange-traded notes (ETNs). Each approach carries unique risk/reward considerations.
What is the best commodity to invest in?
The “best” commodity depends on your capital, risk tolerance, analytical skills, and trading time horizon. Broadly diversifying across different commodities can potentially smooth out volatility.
Are commodity ETFs a good investment?
Commodity ETFs provide easy exposure to underlying commodities. But they carry fund management fees, may track futures indexes instead of spot prices, and don’t convey outright commodity ownership.
Is it easy for beginners to trade commodities?
Commodities carry substantial research burdens into multifaceted global supply/demand dynamics and volatility. Without sufficient knowledge, beginners risk facing catastrophic losses from misjudging market moves. It’s vital to start very small and keep expanding your knowledge.
What should a beginner know before trading commodities?
Key starting points include understanding core commodity characteristics, supply/demand dynamics, seasonality, contract specifications, order types, risk management tools, and avoiding overexposure to any single volatile contract. Consider practicing first with a demo account.
How much money is needed to start commodity trading?
Exchanges typically require a few thousand dollars minimum to open a futures trading account meeting margin requirements. But ideally, beginners should fund accounts sufficiently to endure inevitable early losses without wiping out capital. Start small while refining your strategy.
What is the difference between commodities and stocks?
Commodities represent physical raw materials with prices set by global supply/demand balances. Stocks offer ownership shares in companies with values reflecting business performance, profits, management, and competitive dynamics.
Are commodities more volatile than stocks?
Yes, commodities frequently demonstrate larger price swings than stocks over short time horizons. Their prices are influenced by unpredictable factors like weather and geopolitics. Proper risk management tools are essential.
Conclusion
Commodities form the backbone of global trade flows meeting the world’s relentless demand for raw materials. They offer useful portfolio diversification benefits during periods of elevated inflation expectations or economic slowing when stocks and bonds traditionally struggle. While commodities investing carries higher risks from volatility, the long-term rewards can prove well worth the challenges for dedicated newcomers who continuously build their market knowledge, analytical skills, and risk discipline on the path to achieving trading consistency.
