What is Commodity Trading?
Commodities are the basic building blocks of the global economy. When we talk about commodities trading, oil, gold, and livestock come to mind. These are Natural resources traded on dedicated exchanges around the world. Commodities come in two types; soft, which are agricultural products like rice or sugar, and hard, which comprises metal or energy like silver and gas.
There are other commodities that the market has priced. Every day you are exposed to gasoline, corn, wheat and more. Unless you have been living on a different planet, you will notice that the prices of most commodities have been going up. The emerging market such as China is consuming more resources each day.
Production and consumption of commodities depend on many factors including supply and demand, economic and political events. The dollar also plays a major role here as commodities are priced in U.S. Currency. This means commodity prices can fluctuate.
How to Participate in Commodity Trading
Even though commodity trading uses the same buy-low, sell-high strategy, it differs from stocks. The only difference is the time. Do it in a short period. This is because commodity prices move. They do not move upward or downward continuously like stock prices. Higher prices increase the supply and lower demand for all commodities. Lower prices decrease the supply and increase the demand.
Therefore, the upper-lower limits of commodity prices are rigidly curbed. So, with commodity trading, the buy-and-hold method is not a wise move to make a profit. This also means it is usually not profitable to buy the commodity itself unless the intention is if you intend to receive it physically and use it for your business.
For example., you can buy gold and hold on to it for a long time. The price may go up for a time, but it will fall eventually and will increase along with inflation.
Another disadvantage of holding the commodity is that it becomes difficult to resell for a profit. An investment in commodity does not earn interest or dividends unless you invest in a company that pays dividends. In effect, you are betting your money on the profit of the company and not the commodity.
Timing is everything if you want to make substantial profits in trading commodities. The best financial instrument available for trading commodities is a futures contract. It is a standard forward contract traded on several exchanges that already preset the quantity of the commodity. This includes the selling price and the delivery date.
The future contract's expiration is the same as the delivery date. It enables you to trade the contracts without ever having to own the underlined assets. Commodity prices can be volatile, so it’s vital to keep an eye on the potential downside when placing a trade.
A trader that sells a futures contract assumes a short position and obligates the commodity seller to deliver on time. A trader that buys a futures contract assumes a long position, he obligates the contract buyer to accept delivery according to the terms of the contract.
Trading commodities allow you to speculate on whether commodity prices will go up or down. It is not news anymore that many people trying to make money from commodity end up losing money. Why is that?
It results from poor planning or bad advice. So, how do you avoid the pitfalls of commodity trading? Here are tips for commodity trading.
1. You must do your homework. Know your entry or exit point, which you can do by studying the commodity market. If you are trading based on a tip or recommendation, make sure it is coming from a reliable source.
2. To make a profit from trading commodities you need to forecast the market accurately to a certain degree. Buying low and selling high should be done before the contract expires. This is much more difficult to achieve than investing in undervalued stocks or in companies with high growth potential. In this scenario, the buy and hold strategy works. But in commodity trading, it is not applicable.
3. To become successful, you must have the in-depth knowledge of both the commodity and the market. It also means you must monitor any development that may affect the supply and demand of the commodity. Remember that your commodity price highly depends on the law of supply and demand.
4. Most speculators close out their position before the futures contract expires. They offset their position contract with another contract that has the same terms. The short seller buys back the contract before the delivery date, while the long buyer sells the contract. Offsetting relieves the trader of making or taking delivery of the commodity. Closing the position at a price higher than it was opened generates profit for the trader. You can do the same.
5. Avoid using too much leverage when you don’t have huge capital. Leverage will help you make more profit if things go right, but it will also lead to your downfall when things go wrong. The main thing that kills most small futures speculators is the use of high leverage. They take on a massive position hoping to be right within minutes or hours and are forced to close the position due to low margin.
6. Do not put all your eggs in one basket. This means you should not blow everything on one trade. For example, an amateur trader starts with a capital of $5000 and uses everything on just one trade. Whereas with correct management technique he should not risk more than $200 or $300 maximum per trade.
7. Have a plan to save your profit. This requires the use of a trailing stop which is a type of stop-loss that is only triggered when the market starts turning against you. This will help you save your profit before it turns back to bite you in the ass.
8. A successful commodity trader patiently builds his portfolio. Success does not come overnight. The market is complex and it will take some time before you get that big pay you have been dreaming about. You will have to dedicate plenty of time and energy to trading commodities.
9. Trade with short-term trends because it gives you the best market insight. Do not trade when the market is in consolidation. Find a commodity that is trending up or down, trade in that direction and stick to the 2% money management rule.
10. Watching the financial news and reading commodity reports will add a little sauce to your success. However, many commodity traders use technical analysis to determine their entry and exit points. You must learn the technical analysis methods in commodity trading.