How to Trade Commodities

Trading commodities may be new for many of you, but at the end of the day trading commodities is very much like trading any other market. The first thing you need to decide is what broker you are going to use. There are futures markets, CFD markets, and a plethora of options markets that can help you access the commodities markets. To help you make this decision, simply look at the amount of money you have available to trade with.

Size Matters

Size matters when it comes to trading commodities. This is because of the futures markets. Futures markets are standardized contracts that allow you to trade various commodities. In order to place a trade in the commodity market of your choice, you need to put up the necessary amount of margin to put that position into play, just as you would in the Forex world. This is where futures markets can be a bit expensive for some people. While some commodities are cheaper than others to be involved with, some commodities demand an initial margin well over $5000 for one contract. Beyond that, the standardized contract means that there is only one tick value available. For example, if you were to trade crude oil, each tick is worth $12.50. There are so-called “mini contracts”, but they are normally not as liquid, and still are very expensive for some traders.

This is where CFD providers come in. They allow you to trade less than a full contract, mainly because you are not actually trading on the futures market. You are trading a contract with your broker to pay or receive the difference between the opening price and the closing price. It is because of this that your broker can offer the equivalent of 1 bushel of wheat as opposed to the standard contract size, for example. In that sense, CFD brokers might be a good option for you to consider.

A last choice may be trading commodities on the options markets, but lately options have been extraordinarily volatile and expensive. Likewise, binary options have gotten a lot of bad press lately, and in general can be extraordinarily dangerous because of the high amount of leverage that they offer.

Trading Commodities

Fundamental Factors Differ

Keep in mind that fundamental factors in the commodity markets can be a lot different than what you are used to if you are a stock trader, or perhaps a currency trader. This is because you are dealing with actual “things”, and not necessarily companies or economies. For example, a few years ago there was a long string of floods along the Mississippi River and the surrounding area in the United States. This had a massive effect on the price of wheat, as flooding became a major issue. With crop destruction, this drove down the supply of wheat for the market, which naturally would drive up the price.

It is because of this that the so-called “softs” in the futures markets, which are generally things that grow in the ground, can be a bit challenging for some traders as weather patterns become very important. Typically, when you are trading a currency you do not have to worry about weather, unless there is some type of an anomaly like a tsunami hitting Japan. Overall, weather very rarely enters the equation for currency traders. However, agricultural traders that get involved with wheat, corn, soybeans, and many other markets live and die by weather reports.

Precious metals are a completely different beast as well, as they often react to interest rate expectations coming from the Federal Reserve. Similarly, the price of metals is directly impacted by the strength of the US dollar, as most of the larger precious metals markets are based in that currency. For this reason, it is imperative that you understand how the US dollar fluctuates before you trade gold, silver or other metals.

Liquidity Varies

Another thing to consider when getting involved in commodities markets is the liquidity of the market being traded. Just because your futures broker offers the lumber markets, doesn’t mean that you should be involved in them as they are very illiquid and typically are used for hedging more than anything else. This is not a place for retail traders to be involved. Contrast that with the EUR/USD pair, and you can see that there is a major difference in getting in or out of a position. Many retail traders have been hurt by the lack of liquidity in a market that they don’t understand.

Stick with the Majors

It’s funny that I recommend this, because I don’t believe that to be the case with the currency markets, (although many traders will argue otherwise). This is because commodity markets have varying liquidity, and if you are involved in a futures contract, that liquidity can hurt you as the tick value can be extraordinarily large on some of these contracts. It is because of this that typical retail traders should be trading things like crude oil, gold, silver, corn, wheat, soybeans, natural gas, etc. Getting involved in milk, lumber, or even palm oil may sound exotic, and therefore intriguing. However, it’s an excellent way to lose money.

That’s not to say that you can’t trade these commodities: you just need to have the appropriate account size, which very few retail traders do. At the end of the day, it’s best to stick with markets that are much more stable.

Summary

Find a broker, one that is hopefully either regulated by a strong market authority, or perhaps use one that you already have which offers CFD markets. As a retail trader, you are much better off using CFD markets initially, because you can trade for pennies on the tick, as opposed to such large positions in some of the markets.

Remember that technical analysis works in all markets, to some extent. The more liquid the market, the more likely it is to work. That’s the beauty of some commodity markets such as crude oil, because they are so highly technical in nature.

Fundamental analysis may also be important for commodity trading, as mentioned above, and news may be important as well. Agricultural markets obviously focus more on the weather, while crude oil may focus more on the Middle East. Demand is also a driving factor of commodity prices. Beyond that, I have found that commodity trading works very much like the currency markets and it is a worthwhile addition to your longer-term trading plan.

Christopher Lewis has been trading Forex for several years. He writes about Forex for many online publications, including his own site, aptly named The Trader Guy.