Intro to Commodities
Commodities markets influence nearly all aspects of our daily lives. From the supermarket, to the gas station, to the energy materials that are used to heat and cool our homes, commodities prices continue to impact the world economy on all levels. In the financial markets, commodities can be used as speculative vehicles or as ways of diversifying your broader investment portfolio. Every day, billions of dollars flow through the commodities market, securing its position as one of the most important asset classes in the world.
What is a Commodity?
A commodity is a basic material that is used as an input in the process of producing refined goods. Commodities are interchangeable with other materials of the same type. So for example, brent crude oil from one source is the same material (and used for the same purposes) as brent crude oil from a different source.
There might be differences in quality when comparing commodities from different sources. But the materials themselve are, for the most part, uniform even though they might come from different producers. When commodities are traded on an exchange, commodities must meet certain minimum quality and elemental standards. These standards are sometimes referred to as the basis grade.
How Are Commodities Traded?
Commodities can be traded in both spot markets and in futures markets. Spot markets are associated with real-time prices. For example, spot gold prices might show current as $1,200 per ounce. This essentially means that gold for immediate delivery can be bought or sold at that price (just like in a jewellery store). Spot markets are generally used by businesses and producers that are looking to actually use the materials in question. This is why they are looking to pay spot prices that are immediately valid.
Alternatively, commodities can be traded in futures markets — which are most commonly used by speculators and investors. Here, the commodities themselves are not what is being traded. Instead, investors deal with contracts to buy or sell the commodity at some point in the future. These contracts outline a specific price and time that will be used to complete the transaction at a later date. In most cases, there is no actual delivery of the physical item, as investors will generally rollover their positions or close them out early in order to capture unrealized profits on their positions.
When commodities are traded using futures contracts, there is much greater potential for significant volatility and large fluctuations in price. This is because is it more difficult to get an accurate sense of where market prices should be a month or year in the future. Any time the market environment changes, speculative investors will start adjusting their positions and this will impact the supply and demand dynamics that ultimately determine price. This is how volatility is generated, so this is something to keep in mind as you assess whether you want to be trading commodities via the spot market or the futures market.
How Can I Profit Trading Commodities?
In any investment market, speculators are looking to buy an asset at a low price and sell it at a higher price. This is also true for those trading commodities. But it should be remembered that the commodities market is often characterized by high levels of leverage. Additionally, positioning is conducted through contract sizes (rather than individual shares, as in stock markets). This can quickly magnify the potential for gains and losses, so trading in these markets does require a somewhat conservative outlook in order to keep your trading account protected from negative surprises.
Commodities markets operate 24 hours a day, seven days a week. This adds a high level of flexibility for those that might not be able to actively trade during traditional hours seen at stock exchanges. For those looking to express a market view in grains, precious metals, or oil, commodities markets offer easy access with low trading costs. Some of the most profitable traders in the world focus solely on commodities, so if you have some degree of knowledge in these areas there are excellent opportunities here to achieve long term success. But it is important to avoid jumping into live positions too quickly.
Take your time, accumulate knowledge about the forces that actually move market prices and start trading with a demo account that allows you to become more familiar with the ways real-time market orders are placed. This is the best way of avoiding unnecessary mistakes that can quickly debilitate a trading account and make it difficult to gain traction before you even get started. In this section, we will outline some of the most important factors encountered by those trading in the commodities markets.
Is Commodities Trading Right For You?
Modern financial markets offer many different choices for new investors. Stocks, bonds, options, and currencies are all viable instruments for those looking to express a market view and capitalize on potential trends as they develop. But there are some key advantages that are associated with the commodities space that should be considered by those looking to find new opportunities in the market.
Specifically, adding commodities to a diversified investment portfolio can help to enhance your returns while minimizing your overall risk levels. There are a few different reasons why this is the case. Here, we will look at some of the reasons why people choose to invest in commodities. This will help you to determine whether or not these markets are well-suited for your personal investment style and goals.
Hedge Against Inflation
One of the central reasons people choose to invest in commodities is that is provides a solid hedge against inflation. Over time, almost all currencies depreciate in value — and this is one reason it is unwise to keep your holdings in cash for extended periods. Currency depreciation is also known as inflation, and this is a long-term characteristic of nearly every economy in the world.
But when this occurs, depreciation relates only to the currency — not to the assets that are priced in that currency. When investors are heavily exposed to commodities during periods of inflation, the literal value of their investment climbs while the rest of the market suffers. For these reasons, commodities offer one of the best alternatives available in the market during times when inflationary pressures are building.
Protection from Stock Collapses
Another reason to consider commodities investments is that it can provide protection against collapses in the stock market. Stock markets tend to work in cycles: Broad economic optimism eventually leads to asset bubbles and then once those bubbles burst, a collapse will follow. There have been many instances of this in history, and there is no reason to expect these trends to end going forward. Investors can protect themselves from the negative effects of a collapse in the stock market when using commodities as an alternative vehicle for allocating resources.
The cyclical characteristics in seasonal commodities trends tend to be less drastic when looking at price activity from a long-term perspective. This means that the potential for risk is drastically decreased when investors have at least some exposure to the commodities space. It can certainly be argued that traditional stock investing is the most common asset selection for individual investors. But when we look at the above factors it starts to become clear that a stocks-only approach creates elevated risk levels that are simply not necessary. Many of these risks can be reduced when commodities investments are added to the broader strategy.
Last, we will look at portfolio diversification which is critically important for any investment strategy. Portfolio diversification simply means that investors can greatly reduce risk when spreading their resources across a larger number of asset classes. In other words, it is unwise to “put all your eggs in one basket” and devote all your resources to any one asset. Those that have all their money in stocks would be particularly vulnerable if we were to see a cyclical downturn in equities.
Investors that have their positioning in more than one asset class would see those losses balanced out by gains seen in inversely correlated markets. In essence, this means that it is nearly impossible to break the bank — and lose your trading account — even if an unexpected, catastrophic event occurs in the markets. This approach provides peace of mind and an added layer of security , no matter what the environment. This is another reason investors can benefit from commodities exposure as part of a broader strategy.
In sum, commodities investing does include its own set of risks — no different from any other asset class. But there is a strong set of reasons for why investors should at at least some commodities exposure to a broader portfolio strategy. For these reasons, it makes sense to have a strong grasp on the benefits that can be captured when dealing with these markets. This will help you to position your trades in ways that allow for proper risk management and limitations placed on the potential for excess losses.
Risks of Commodities Trading
When we are getting started in the commodities trading markets, it can be very easy to become distracted by the promise of fast money. But it must be remembered that successful trading in any financial market is not gambling — and a proper assessment of the risks involved must be conducted before any real money trades are placed. Commodities trading should be viewed as a business, rather than as a trip to Las Vegas. When traders fail to adopt this mindset, excessive losses usually follow in short order. Here, we will look at some of the most significant risks that face commodities traders. A proper understanding of these risks will help to limit unnecessary losses during your trading career.
Risk and Reward
Before any commodities trades are placed, investors must understand that this is ultimately a game of risk versus reward. To be sure, the potential for profit is substantial — and plenty of commodities traders have made a fortune trading in these markets. But they were not able to accomplish this without first realizing that the potential for risk (and loss) if just as large.
Most people possess a natural aversion to risk. There are solid, biological reasons for why this is true — and in almost all cases it is a very good thing. If you are trying to cross a street full of speeding traffic, it is usually a better idea to wait until that traffic dies down before taking the risk to cross the street.
Commodities markets are no different, and this is why it is generally a good approach to take things slow and not try to master the market all at once. There is a relevant quote to be taken here from humor writer Will Rogers, who said that he is less “concerned about the return on my money as I am about the return of my money.” This is a cogent point and one that should be remembered by commodities traders that are looking to make a career profiting from these markets.
One of the elements that attracts most people to commodities markets is the large trade sizing that can be commanded through leverage. But what most new traders miss is the fact that excessive position sizing is of of the leading cases of risk-based loss in the commodities markets.
Imagine that you walk into a casino with $10,000 and decide to take your chances at the roulette wheel. The minimum bet at the table is $10, and the maximum bet for the table is $10,000. How should you approach your strategy? If you decide to place all of your money on the table at once, it should not be entirely surprising if you see things work adversely against you, and you ultimately lose all of your cash. If you decide to place your bets in smaller increments, you have significantly reduced your risk and allowed yourself to play at the table for a longer period of time.
Commodities trades work the same way: Money that is not put at risk cannot be lost. This is why most experienced traders use only small portions of their trading account in connection with any one position. The overriding theme here should be clear. Commodities trading should be viewed as a marathon, rather than a sprint. Any trader that thinks he can master the market with little trading and no patience is destined to fail — and lose all of his money in the process. If commodities trading were really that easy, everyone would be doing it — and everyone would be wealthy.
Avoiding Risk in Your Trades
But, unfortunately, the basic stats show us that most new traders fail. By some accounts, commodities brokerage data has shown that up to 98% of new traders lose money. Why is this the case? Mostly, this occurs because new traders enter these markets with unrealistic expectations and the belief that anyone can get lucky (and rich) overnight. Any amount of rational thought would tell us that this is simply not possible. So, what you should really be asking yourself as a new trader is this: How can unnecessary risks be avoided?
As simple as it sounds, the best way to avoid risk in the commodities markets is to exercise patience and conduct proper research before any real money trend is placed. Commodities trading needs to come with a certain level of prudence if you are going to be able to stay in the game long enough to achieve true profitability. These are basic rules that cannot be avoided, and must always be remembered when real money trades are being executed in the market.
Commodities and the Law of Supply and Demand
The laws of supply and demand are vital in determining a trading outlook for any financial market. But it can be argued that these factors are most relevant for the commodities space. This is because commodities are not tied to any single company (as in stocks) or to any specific nation (as in bonds or currencies). In those markets, traders can watch for the next earnings report or macroeconomic release as a method for determining where valuations are likely to head next. But since this is an impossibility for commodities traders, different factors will need to be considered.
Enter the laws of supply and demand. These laws strip down economics to the basics — which is entirely appropriate given that commodities provide the building blocks many businesses need to produce the items that are fit for public consumption. For these reasons, new traders will need an understanding of the ways market experts analyze the forces of supply and demand. This is the best method for conducting fundamental analysis in the commodities markets. Here, we will look at the various ways supply and demand can impact commodities prices.
Production and Inventories
When commodities traders are looking to assess supply levels, the first place fundamental analysts will research is the market inventory. How much of the asset is available for purchase at any given time? This is important because declines in supply tend to push prices higher. When many people are looking to buy an item and the available supply of that item is small, the consumer base will be willing to pay more for that item. As a general rule, low supply means high prices. Large supply means lower prices. This information can be very useful when commodities traders are deciding whether to buy or sell an asset.
So how can traders assess the level of available supply in the market? Ultimately, this depends on the type of asset that is being traded. For example, oil traders will often look to the inventory report that is released by the United States Energy Information Administration each week. The US is the world’s largest consumer of oil, so the inventory level seen in this market is critical in determining how much supply is available in the market.
For agricultural traders, crop reports become critical. Major changes in weather patterns can destroy crops and limit productivity. This could mean reduced supply in the market and this would be a bullish event for the soft commodities space. In metals, it becomes important to view the quarterly reports released by mining companies. Were these companies recently able to pull more gold or silver out of the ground? If so, more product will be made available to consumers. This would be a bearish event for precious metals markets, and likely lead to a strong round of selling.
In these ways, commodities traders are able to assess market supply levels and then base positions on the underlying economic trend.
Manufacturing and Consumer Trends
On the other side of the equation, commodities traders will look to assess the level of demand for an asset that is present in the market. This is a more complicated task, as it requires a forecast of what is likely to happen in the future. Will the market start buying the asset? Or wait for a later date when prices are cheaper? This is harder to assess than a supply level, which is something concrete that can be accurately measured. But this does not mean that commodities traders should overlook demand assessments. In fact, these assessments are critical in determine instances where price volatility is likely to increase.
The broadest way of assessing what level is demand is likely to be seen in the future is to watch the macroeconomic data. Strong trends in these areas suggest that consumers will have more buying power. This tends to create inflationary pressures which raise valuations for consumer products and for the commodities themselves. Factors like the unemployment rate, GDP (at both the national and global levels), inflation, and retail sales can be assessed to determine which trends are currently present in the market.
Other areas to watch can be located in areas like factory output and manufacturing productivity. These are the places where most commodities are bought and sold, so increased activity here suggests that broader demand is rising. These types of reports are regular features on market economic calendars, so these are things that should be on the radar of every commodities trader.
Overall, it might seem difficult to accurately measure the levels of supply and demand that are present in the commodities market. But there are common practices that commodities traders use which can be helpful in determining the broader trends. Conducting research in these areas will be vital for traders looking to conduct a proper fundamental analysis of these assets.
Hard and Soft Commodities
It might be true that all publicly traded commodities are fungible, but there are still some classifications that are made to broadly separate commodities into two categories. Specifically, this is where traders start to encounter the distinctions made between the hard commodities and the soft commodities.
These might seem like vague distinctions. But these distinctions are actually quite useful in the ways they allow commodities traders to define strategies and assess which financial and environmental factors are going to be most relevant in each active position. Here, we will look at the types of commodities that fall into each category and then discuss some of the factors that impact the trades that are made in each category.
First, we look at the hard commodities, which tend to get the most attention when we look at the financial news headlines. Generally speaking, hard commodities are mined out of the ground or otherwise extracted from another natural resource. Some of the more popular commodities in this category include gold, silver, copper and aluminum.
Oil also falls into this category, which might seem counterintuitive because it is not a material that is physically “hard.” But it is still extracted deep out of the ground from other natural resources, and it is usually placed into this first category. Another characteristic that describes the hard commodities is that the original products are refined into new products. This is also the case for oil, as it it later refined into gasoline for energy consumption in things like automobiles.
In most cases, hard commodities are much easier to handle and transport when compared to the soft commodities. Hard commodities have a more efficient level of seamless integration with the industrial process — and this tends to be the area where most commodities investors position themselves. It could be argued that some of these trends will start to change in the future as soft commodities like sugar and corn continue to be used in energy products that are ethanol-based. But even with these recent trends, there is no denying that hard commodities dominate the commodities market in general. Each year, trillions of dollars flow through the oil futures markets alone, so it is relatively clear where the majority of commodities traders are centering their attention.
Here is a list of commonly traded assets that fall into the hard commodities category:
- Crude Oil
- Natural Gas
- Heating Oil
- Gas Oil
- Unleaded Gasoline
Next, we look at the soft commodities. This asset class is less commonly traded but still plays a significant role in the daily trading volume that is seen in the commodities market. In most cases, soft commodities are farm products that are grown (rather than being mined in the case of hard commodities). Some of the most popular assets in this category include corn, wheat, orange juice, coffee, sugar, cocoa, and pork bellies. It might be clear here that many of the soft commodities are vulnerable to spoilage and this can drastically complicate transportation issues.
When there are problems growing or transporting the soft commodities, supply levels can be negatively impacted without much in the way of advance notice. In commodities, this is generally a recipe for one thing: enhanced short-term volatility. Imagine you are holding 10,000 pounds of No. 2 yellow corn and transportation issues keep them from being delivered on time. You would then be forced to either sell them at a reduced price or to dump the lot entirely. This could have a material impact on the market supply of corn and cause price changes that could not have been anticipated.
Volatility, of course, can be positive or negative for any given trade. Reduced supply would generate massive gains for those holding long positions. Things would not be so great, however, for those that have sold short corn. For these reasons, trading decisions in the soft commodities need to be well structured and perfectly timed. When this is done correctly, it is possible to accumulate significant profits in a short period of time.
Food producers tend to make up the majority of the positioning seen in the softs market. This is because farmers or food manufacturers will often hedge their asset portfolio by selling a futures contract to lock-in a set price for the future. These transactions, along with the natural seasonality associated with agricultural materials create predictable price trends in the broader market. These are factors that must be assessed before any real money investments are initiated in this space. Here is a list of some of the most commonly traded assets in the soft commodities market:
- Pork Bellies
- Orange Juice
- Live Cattle
- Soybean Oil
- Soybean Meal
The commodities market is full of terminology that initially might seem difficult to understand. But with a little research, repetition and patience new traders can quickly overcome many of these difficulties and become familiar with the complexity of these markets. One of these seemingly-complicated terms that you will almost certainly come across in your commodities trading is the concept of fungibility.
Here, we will look at what the terms actually means and why this is important for those actively trading in commodities.
Fungibility refers to the ways a specific asset is interchangeable with other assets of the same type. For example, one barrel of crude oil that is produced in Saudi Arabia is worth one barrel of crude oil that is produced in Alberta, Canada. Both of these products will trade at the same market value even though they might have been produced by different companies at very different locations. When commodities possess this property, it makes it much easier for exchanges to offer trader access to these materials and to standardize market prices.
The idea of interchangeability implies a similar value for all goods in a specific class, and that those goods should be made available to the market at the same price. Without this, it would be nearly impossible for global commodities producers to make their assets available for trading on common exchanges. This would severely limit the number of assets that would be made available for speculative trading, and encourage black market activity to transport goods between countries. Needless to say, this would greatly complicate the ability of investors to accurately price raw materials — and this would make it very difficult for the speculative commodities market to exist at all.
Which Assets are Considered Fungible?
Many different asset types are considered fungible. This would include commonly traded assets like gold and oil — but also more diverse assets like meats and grains. If you talk to a gourmet chef, there might be arguments about differences between the sources of pork bellies or the oranges that are used to produce orange juice. But when we are looking at these assets as publicly traded commodities, many of those differences are erased (at least in terms of market valuations). This is useful because the standardization makes it much easier for speculators to take an active stance in the market.
But this does not mean all assets are created equal. For example, corn that is classified as No. 2 yellow corn is going to show specific differences when compared to the No. 1 yellow corn variety. Brent crude oil is not the same as light crude oil. There are going to be large differences in the various ways that specific commodities types are used to generate refined products. Other fungible asset types show fewer differences. An example here could include a commodity like gold, which has a very specific definition as an element that is found in the earth. But all of these assets are tradable commodities, and are considered fungible in active trade.
What it Means for the Market
Fungibility is an important aspect of the commodities market that allows for true standardization in prices and broad access to raw materials produced around the world. Without this practice, it can be argued that commodities trading would not exist as it does today. At the very least, removal of fungibility would shut off access to these markets for a large majority so this is a vital aspect of the market that must be understood by all active traders. Fungibility is also what allows us to speculate in large quantities of meats, grains, energy products, and precious metals.
As far as the commodities market is concerned, there is no substantive difference between copper that is produced in Europe or Australia. It is simply thought of as “copper” and that copper is associated with a specific price per ton. Fungibility removes any differentiation between global products, and market prices trade as a direct result of changes in supply and demand for those materials. This means that corporate branding has no place in the commodities markets, and these present some of the key differences between what is seen in the traditional stock arena.
Common Volatility Drivers
According to some traders, the commodities markets are associated with the highest level of volatility when compared to the other major asset classes. Whether or not this is entirely true is up for debate. But what cannot be denied is that there are certain fundamental drivers that can cause unexpected fluctuations in short-term price activity. This increased volatility can make it difficult for new traders to structure positions in ways that are truly protected from loss.
For these reasons, it makes sense to have some idea of the types of things that can add to the environment of unpredictability and make it more difficult to manage your positions. As Ben Franklin said, “an ounce of preparation is worth a pound of cure.” So, if you are aware of the types of things that are likely to jar markets, you will be able to more easily spot them in their early stages. Here, we will look at some of the most common volatility drivers that can be found in the commodities markets.
When we look at the common risks that face the commodities markets, we must first look at the real causes of surprise volatility. Volatility is essentially the rapid fluctuation of price activity, and when this occurs it is often something that catches the majority of the market off-guard. One such factor is global economic uncertainty, and this is something that can take shape in a number of different forms.
One well-known example could have been seen during the stock market collapse of 2008. Other examples might be seen in the deteriorating economic data of one of the world’s larger economies, or geopolitical turmoil in oil-producing countries. Whatever the case, a more negative outlook for global economic growth will almost always weigh heavily on commodities markets, as this essentially means that slowing manufacturing productivity will create reduced demand for raw input materials.
When these types of scenarios occur, oil markets are generally the first to take the hit. This is because companies will not require as much energy to run their factories. As a general rule, declining economic data should be viewed as negative for oil and can be used as a basis for taking short positions in the commodity.
In the soft commodities space, one of the biggest drivers of volatility can be found in unexpected weather changes. Any scenario that leads to the destruction of crops or the inability of farmers to produce as much as was seen during the previous season can quickly market prices into disarray. Key commodities that will be affected by these types of events include wheat, corn, and orange juice — although most of the soft commodities are vulnerable to extreme changes in weather. For the most part, any event that limits productivity and supply levels will increase valuations for that specific commodity. So while the destruction of crops might seem like a negative, it is actually a bullish event for market prices. For these reasons, severe weather changes will often push commodities investors to establish long positions in the assets that are most directly affected.
Safe Haven Buying
The last event we will be looking at here is the need for widespread safe haven buying in the market. Specifically, safe haven assets refer to trading instruments that have a long-established history and can be used as a store of value when market volatility is increasing.
When we look at commodities, two of the most obvious choices that fall into this category can be found in precious metals — specifically, gold and silver. So, for example, if we start to see big declines in the global stock benchmarks, investors will need to find an alternative store of value in order to “ride out the storm” and avoid the volatility. In these types of scenarios, it is not uncommon for investors to move their money out of stocks and into the safe haven security of gold and silver. This wave of buying activity can increase short-term price fluctuations in these assets — and this adds volatility to the precious metals section of the commodities market.
All of these are factors that should be considered by commodities investors before any real money trades are placed. If you are aware of the scenarios that are likely to bring volatility to your chosen asset type, you can avoid placing trades or even look to capitalize on the larger price changes that are likely to take place. Strategies all depend on your level of risk tolerance and whether you consider yourself to be an aggressive or conservative trader.
Commodities Chart Analysis
For new commodities traders that are interested in basing their market positions on technical analysis, price charts are the most important tools available. At first, the charts themselves might seem like they are difficult to understand. But once they are stripped down to their basic elements, things start to become much more familiar. Here, we will look at some of the factors involved in understanding how price charts work — and how they can be used to place real money trades in the commodities market.
First, we need a proper understanding of the charts themselves. There are a few different chart types that can be used. But all of them plot market prices on the Y-axis, and time values on the X-axis. This is important because it ultimately implies that price and time are the two most important factors when commodities traders are looking to place trades based on price chart assessments.
The most basic chart type is the line chart. An example can be seen below using historical price chart in oil:
Chart Source: Metatrader
As you can see, this simple chart shows traders price and time — and nothing else. Here, the valuation levels that are plotted show prices at the close of each trading period. Since this is an hourly chart, each time interval is equal to one hour. So, when we see prices trading at 75.55, the indication is that commodities markets valued oil at $75.55 at the close of that specific hour. Line charts are useful for commodities traders that are looking to get a quick sense of where prices are trading at any given moment. But if more in-depth technical analysis is going to be conducted, there are other chart types that are more useful — and more commonly used by technical analysis traders.
Next, we will look at the same historical price information in oil. But, here, we will plot that data using a candlestick chart:
Chart Source: Metatrader
Here, we can see a more colorful price chart that gives technical analysis traders a bit more information. This is the exact same price information for the oil commodity, but here we can see more of a separation between time intervals. Again, this is an hourly chart. But each our in this case has clearly defined price plots that show the open, close, high, and low for the period. Additionally, each interval is defined as either bullish or bearish. In this chart, the red candles are bearish candles (where the closing price is lower than the opening price). Green candles are bullish candles (where the opening price is higher than the closing price). This additional information can be quite useful in placing commodities trades, and this is the reason candlestick charts are most commonly used by technical analysis traders.
Choosing Time Frames
The next important element in commodities price charts is the time frame that is used. Time frames are critical for commodities trading because so much of whether or not a position is successful will depend on how prices close for a given time period. It should be noted that this is even more important for commodities traders that express their market views using futures contracts (rather than in spot markets).
Let’s again look at a price chart in oil. But in this case, we will change to a daily time frame:
Chart Source: Metatrader
Here, the asset in question (oil) is still the same. But the price information is very different. In this case, each candlestick represent one day. So, the open, close, high, and low will be determined by the price activity that took place over each trading day. Because of this, the price information that is seen on the price chart as a whole is much larger in nature. An hourly chart might show the total price activity that took place over days or months. A daily chart might show the total price activity that took place over months or years. These factors are critical for technical analyst traders that are trying to decide how long a specific position should be held.
In all, commodities price charts might seem difficult to understand when first encountered. But once we understand the basic elements that are used to view price activity, things become much easier to understand. The chart type and the type frame used are critically important for those looking to establish real money positions. Without this understanding, traders could make costly mistakes that could have been avoided.
Commodities Trading Strategies
Before you make any real money commitments in the commodities markets, you will need to settle on a strategy that allows you to profit over time. This does not mean you will need to win all of your trades in order to achieve true profitability. Ironically enough, you don’t even need to win in half of your trades. But you will need to devise a strategy that generates profits that are larger than your cumulative losses. This might sound simplistic — but this is why most novice commodities traders fail when they first start trading in these markets.
To accomplish long-term profitability, the first requirement is an understanding of the basic strategies that are used to assess strength or weakness in commodities markets. There are two broad approaches that commodities traders use when making forecasts to determine a positive (bullish) or negative (bearish) outlook for a specific asset. Here, we will discuss these market approaches so that new traders can start assessing which method will likely work best to achieve your personal investment goals.
Fundamental Analysis of Commodities
First, we will discuss the most traditional method of commodities valuation: Fundamental analysis. When conducting fundamental analysis, investors will look at the underlying economic factors that determine the value of a specific asset. Fundamental analysis of commodities requires an assessment of the broader trends in supply and demand that influence valuations and price activity. Generally speaking, rising demand will positively influence prices while rising supply will negatively influence prices. So there are essentially two opposing forces that commodities traders will need to consider when conducting fundamental analysis.
On the supply side, fundamental analysis will need to assess the activities of commodities producers. Are farmers producing crops at a greater rate than the previous month or year? Are miners finding more precious metals at their resource locations? Have oil drillers exceeded expectations in their output levels for energy products? These are some of the most important questions that will need to be asked in order to make a proper assessment of commodities supply that can be found in the market.
On the demand side, assessments must be conducted more at the consumer level. This is because demand, by its nature, implies that purchases will need to be made. For the most, purchases can only be made once an item is produced, so here we are already one step beyond the producer level. When assessing demand, macroeconomic data provides some of the most useful information. Have productivity levels started to rise in factories around the nation? Is there a strong labor force that can support retail sales going forward? Are there positive trends in the real estate market that support new construction and building? Are there weather forecasts that suggest consumers will need to buy more oil to heat or cool their homes? These are the types questions that will need to be asked in order to make a proper assessment of commodities demand that can be found in the market.
Technical Analysis of Commodities
The second common method for making forecasts in the commodities markets is technical analysis. When using this method, commodities traders will use historical price charts to assess trends and determine price levels where markets are likely to start buying or selling an asset. The central logic is that price trends that happened in the past are likely to occur again in the future. In this way, commodities traders will use various technical analysis methods to identify price points where significant buying and selling activity occurred in the past. Traders can then place buy and sell orders to trigger positions once those important historical levels are seen again in the future.
Technical analysis is very different from fundamental analysis because there is no real attention paid to the economic factors that might influence price activity in an asset. Instead, traders will focus solely on price charts and make decisions based on whether an asset has become expensive or cheap relative to its historical averages.
For these reasons, technical analysis tends to be much better suited to those with mathematical aptitude. Fundamental analysis tends to be best suited to those with a strong understanding of macroeconomics. Neither approach is “better” but there are some key differences that should be understood before any approach is use as a basis for establishing real money trades. Furthermore, there is nothing to suggest that these approaches are mutually exclusive. This means that traders can draw from both sources when conducting the analysis that is required to place trades in the commodities markets.