Commodity Trading Guide

Adam Lemon

With so many brokers offering commodities these days, you might be thinking of branching out beyond Forex and stocks. With so much volatility in commodity prices, there is money to be made. Read on to get the lowdown about this exciting asset class, why it can offer great opportunities to profit, and how to trade commodities.

What is Commodity Trading?

Commodities are goods which can be bought and sold, usually very easily. They are often goods which are bought regularly by people in their daily lives or used by businesses in manufacturing. This is what makes commodities different from other asset classes like stocks and Forex. Examples of commodities which are offered for trading by Forex / CFD brokers include precious metals (like gold and silver), industry fuels (like crude oil), and agricultural goods used in foods (like soybeans and wheat).

The main special characteristics of the commodities market are:

  • Commodities are often subject to huge price fluctuations, especially during times of crisis affecting their production. This makes commodities very attractive to traders and investors, because the bigger the price movements, the more profit which can potentially be made.
  • Commodities are raw materials which many people all over the world need.
  • Commodities are extracted from nature. They are natural resources.
  • Commodities are very uniform. For example, one barrel of WTI Crude Oil is just like another.
  • It is common for some commodities to only occur in certain countries or regions, making these strategically important producers. This can generate political tensions and even war.

In commodity trading, commodities are usually grouped into four wide categories, each of which can be further divided into sub-categories. The wide categories are metals, energies, livestock, and agricultural commodities. Let’s take a closer look at each of them.

Metals

Many different metals are traded in commodity markets. They can be divided into two categories: precious metals, which are prized as a potential store of value, and industrial metals, which as the name suggests, are used in construction and other industries. There is an overlap as some precious metals, notably silver but also gold and others, do have industrial uses.

The most widely traded precious metals are:

  • Gold
  • Silver
  • Platinum
  • Palladium

The most widely traded industrial metals are:

  • Copper
  • Aluminum (Aluminum in US English)
  • Zinc
  • Tin
  • Iron Ore
  • Steel (technically steel is an alloy, not a metal)

Usually, the prices of industrial metals move more than precious metals. This is because industrial metals are more subject to supply, demand, geopolitical, and macroeconomic factors than precious metals are. It is sometimes argued that precious metals are a kind of currency, and that they often behave like currencies because they are seen as stores of value. For this reason, they are sometimes considered to be part of the Forex (currencies) asset class.

Energies

Energies are fuels that are used in industries, private homes, and transportation. Today, major energies are all fossil fuels and are extracted from the ground. Their prices are usually very responsive to changes in rates of economic growth and consumption and are often positively correlated with stock markets. However, their price movements can be extremely volatile.

The most widely traded energies are:

  • Crude Oil
  • Natural Gas
  • Gasoline
  • Heating Oil
  • Coal (this is quickly becoming less important)

As the world tries to reduce use of fossil fuels to slow the pace of climate change, it may be expected that these traditional fossil fuels will become less important within commodities markets and may be replaced by cleaner energies.

Livestock

Livestock commodities are animal products, excepting poultry and fish. Despite the “live” part of this categories term, most livestock commodities are not traded in living form.

The most widely traded livestock types are:

  • Live Cattle
  • Lean Hogs
  • Feeder Cattle
  • Pork Cutouts

As we see greater emphasis on the ethical issues and environmental impact of the consumption of animal products by humans, it may be that we will see a decrease in global meat consumption and a shrinking livestock sector. Some traders and investors may have ethical issues with speculating in animals, especially as more nations work to place greater restrictions on the transportation of live animals.

Agricultural Commodities

Also known as “soft commodities,” agricultural commodities are products which are grown, not extracted from the ground. They are mostly farmed foodstuffs, but there are also non-foodstuffs in this category like rubber which is partly made from tree products. Most people are instinctively familiar with agricultural commodities because their production has had a central place in human culture for over ten thousand years.

An important subgroup within this category are the “grains” such as wheat, corn, and rice.

The most widely traded agricultural commodities are:

  • Wheat
  • Corn
  • Soybeans
  • Rough Rice
  • Oats
  • Palm Oil
  • Sunflower Oil

Agricultural commodities are obviously very important products because they are staples of human food consumption and survival. Their prices are very dependent upon weather, especially extreme weather events, and sometimes geopolitical factors like wars or unrest when supply is disrupted. The prices of agricultural commodities can change dramatically in just a few months: it is not unusual to see a commodity increase in value by four times within a year. This makes agricultural commodities especially attractive to speculators and trend traders.

What Instruments Should I Use to Trade Commodities?

Commodity trading is the process of buying and selling commodities, or instruments reflecting the values of commodities, where you attempt to sell higher than you bought, or buy back lower than you sold.

It is usually not practical for traders to buy the actual commodities themselves, due to storage issues – storage can be expensive, and quantities very large. Therefore, commodity traders choose from several other ways to get exposure to commodity price movements offered by commodities brokers, in the hope of profiting from them. The pros and cons of each method are shown in the table below. However, it should be noted that most serious commodity traders are commodities futures traders, using futures to get exposure to commodities.

 

Instrument/Method

Pros

Cons

Futures

  • Usually effectively tracks the underlying commodity
  • No overnight fee (already priced into spread)
  • Very liquid
  • Wide availability of commodities futures at futures brokers  
  • Size of 1 futures contract may be too expensive for many retail traders, but micro contracts available for some commodities
  • Price may gap when market offline

ETFsand Notes

  • Very affordable, many commodities ETFs available for only $20 per share
  • Commodity ETFs often own futures in the underlying commodity and can track its price very effectively
  • ETFs are widely available through ETF brokers
  • Can be hard to find for some commodities
  • Extra risk of the ETF or note itself, which could collapse even while the underlying commodity’s price performs well
  • ETFs and notes may not be as well-regulated as widely believed, especially during extreme price movements in the underlying
  • Notes are less solid than ETFs

Options on Futures

  • Options precisely define and limit maximum risk, unlike futures and ETFs
  • Options can produce excellent outsized gains in reward to risk terms
  • Options can be purchased at different strike prices, allowing sophisticated trading strategies 
  • Very expensive, with the cheapest trade at the money typically costing a few thousand dollars
  • Liquidity issues possible especially for far out of the money (OTM) options

Options on ETFs

  • See Options on Futures above
  • May be expensive for retail traders, with the cheapest trade at the money typically costing a few hundred dollars
  • Liquidity issues very possible especially for far out of the money (OTM) options
  • Additional fund risk

Mutual and Index Funds

  • Very affordable
  • Widely available
  • Mutual funds usually own shares in commodity extracting companies, making weaker correlation with commodities prices more likely
  • Additional fund risk

Commodity Stocks

 

  • Very affordable
  • Widely available
  • Can combine best of commodity and corporate value
  • Companies extracting commodities may have share prices only weakly correlated with those commodities, making this an unpredictable vehicle
  • Additional corporate risk

Commodity Pools / Managed Futures

  • Can generate excellent profits by sophisticated commodity trading / investing strategies using appropriate leverage
  • Can be professionally and skillfully managed
  • Minimum deposit can be very high, forming a barrier to entry for retail traders / investors

CFDs

  • Extremely affordable with very low minimum deposit
  • Widely available through CFD brokers
  • CFDs usually track the underlying commodity very closely
  • Can be suitable for short-term/day trading
  • High overnight fees make trend or long-term trading very challenging
  • Additional broker counterparty risk
  • Spreads and commissions can be relatively high


 

Now I have covered what commodities and commodity trading are and examined the pros and cons of the range of instruments which can give exposure to commodity prices, let’s see how some effective commodity trading strategies can work.

Commodity Trading Strategies

There are two main technical trading strategies used to trade commodities:

  • Trend following
  • Buying low at bullish reversals

These are longer-term strategies. Commodity day traders usually use the same kind of day trading strategies used by Forex traders.

As well as these two technical strategies, there are a few tools which can be used as filters, or which can be used to build unique trading strategies, such as the commitment of traders (COT) report, seasonality, economic fundamentals, and political or environmental intelligence. For example, some hedge funds use satellite imagery to view the condition of agricultural commodities which are growing and from this forecast the quantity and quality of the next major harvest. This is obviously beyond the reach of retail traders.

Let’s examine at the two most common technical strategies used in trading commodities by retail traders.

Trend Following

Trend followers try to buy commodities when they are breaking to new high prices, or to sell them when they are breaking down to new low prices. A stop loss should always be used in trend following, and is often based on average recent volatility, which can be easily measured by the average true range (ATR) indicator. Profits are taken by using some type of trailing stop.

Trend followers accept a relatively low win rate but can be profitable over time as the small number of very successful trades eventually more than make up for the larger numbers of losers.

Trend following strategies use slightly different trade entry and exit strategies, but they are all basically the same. My favorite trend following strategy for trading commodities has been very profitable in recent years and it is also very simple. I like to use commodities ETFs as they are very affordable and quite liquid, but this strategy can work very well with futures or options also. The strategy works like this:

  • Choose a wide range of commodities ETFs across all categories of commodities, one for each major commodity. I use about 20, but if you use commodity futures there are many more to choose from.
  • At the end of each calendar month, check whether any of the commodities you are monitoring has closed at either a 6-month high closing price or a 6-month low closing price.
  • Open a long trade in any commodity which closed at a 6-month high, or a short trade in any commodity which closed at a 6-month low.
  • Enter a hard stop loss at the point where the commodity makes a 10% loss. No losing trade should cost you more than 1% of your equity, ideally even less, so size positions accordingly.
  • Exit the trade 6 months later if it has not yet hit the stop loss.

This strategy can be customized in several ways, especially by moving up the stop loss in winning trades. If a commodity keeps making new highs over several months, this strategy will have you pyramiding into a winning position.

I have back tested this strategy over more than 10 years using 18 commodity ETFs, without a stop loss. The results show that 53.57% of trades would have been winners, with the average trade generating a positive result of 1.85%. Long trades produced a much higher average profit (3.25%) than short trades (0.60%) because commodities have historically been more prone to explosive moves to the upside than downwards. You might consider trading a commodities trend following strategy and only taking long trades.

Just look at the historic price charts below of several major commodities to see how big the changes in price can be, offering great opportunities for profit:

WTI Crude Oil Price Chart 2006-2022

WTI Crude Oil Price Chart 2006-2022

WTI Crude Oil has fallen from $140.00 to $0.01 per barrel, then risen back up to $85, over recent years.

Copper Futures Price Chart 2015-2022

Copper Futures Price Chart 2015-2022

Copper futures have risen from $330 to $800 in less than two years.

Teucrium Corn ETF Price Chart 2010-2022

Teucrium Corn ETF Price Chart 2010-2022

The Teucrium Corn Fund ETF has fallen from $52 to $12 in less than a decade and has almost doubled in value over the past 18 months.

Buying at Historic Lows

This strategy tries to take advantage of the historic long bias of the commodities market since the 1970s.

  • Choose a wide range of commodities futures, ETFs, or options across all categories of commodities, one for each major commodity.
  • You can trade this either on monthly, weekly, or daily charts.
  • Wait for a commodity to make a long-term low, for example its lowest price in 1 year.
  • Watch for a strong bullish candlestick to reject that long-term low on relatively high volume (unlike Forex, volume data for commodity futures and ETFs is publicly available). Checking the open interest in the Commitment of Traders Report (COT) can be another filter to use to validate the trade entry signal (the COT should be long on balance). This and high volume should indicate there is a lot of buying going on, increasing your chance of entering a profitable trade.
  • Enter a long trade, placing a hard stop loss below the long-term low.
  • A variety of exit strategies may be used.

This strategy can work well, but I think the 6-month trend following strategy I outlined is superior.

Fundamental Strategies

The price of a commodity, like the price of anything, is determined by the law of supply and demand. This is the economics of trading commodities. Fundamental commodity trading strategies try to anticipate shifts in the supply and demand for commodities by looking at the following factors:

  1. Macroeconomic factors. For example, booming economies will have more demand for Crude Oil, so forecasting economic growth means you can try to forecast the future price of Crude Oil. Times of high inflation rates also tend to see increases in commodity prices.

  2. Long term weather forecasts. These can be used to predict the quality of agricultural commodity harvests, which basically are supply.

  3. Mining / extraction intelligence. If a huge deposit of natural gas is discovered but that information is not yet publicly available, this may be used to anticipate increased supply which could lead to a fall in the commodity’s price.

  4. Corporate extraction activity / plans.

  5. Political intelligence. Being aware of a likely policy change concerning the extraction of a commodity from a country which is a major supplier can be an edge.

  6. Seasonality. Demand for many commodities tends to fluctuate somewhat predictably by time of year. For example, there is much more demand for heating fuels in winter than in summer.

Some or all these factors can be used to build a commodity trading strategy, or as filters for entering trades or taking a larger than usual position.

I think that retail traders should pay more attention to technical factors in trading commodities than these fundamental factors.

Should I Trade Commodities or Stocks?

You do not have to choose between trading commodities or stocks – there is no reason why you cannot trade both. Both asset classes have always been especially attractive to traders as they are the two asset classes which enjoy the biggest movements in prices.

There are several things to consider about the differences between trading stocks and commodities before you make any decisions about which asset class to focus on.

  • Cheapness / Accessibility

Stocks usually cost less to trade than commodities. Also, many stocks are cheaply priced, while commodities futures and options cost much more per unit. However, these are not good reasons on their own not to trade commodities, it is just something to be aware of.

  • Volatility

Commodities are the most volatile asset class, except cryptocurrencies. However, there are many stocks which see just as much price movement as commodities. The problem is how to choose them. There are about 25 major commodities, and these certainly see a higher average volatility than all the publicly traded stocks on the market.

  • Long Bias

Stock markets have a long bias, meaning they usually rise in value over the long term. This means that if you are buying and holding stocks, you have a theoretical edge in your favor. However, commodities have also shown a long bias, although not as much as the US stock market does.

  • Leverage

Many brokers and regulators allow higher leverage on commodities than on stocks, meaning you can get more value for your deposit in trading commodities than in trading stocks. Excessive use of leverage can of course be dangerous, especially in trading the volatile asset class of commodities.

  • Market Manipulation

Jesse Livermore, the greatest trader of all time, said he preferred to trade commodities over stocks because they were harder to manipulate, so the price behaved more “honestly.” Livermore said this in an era when stock markets were much less regulated and more prone to insider trading and other abuses than they were today, but there is still something in his point. The factors which influence supply and demand for commodities are usually bigger and harder for anyone to control than the factors which can strongly influence the price of an individual company’s stock.

Final Thoughts

Commodities are an asset class that should not be ignored by anyone wanting to make money trading financial markets, because they are likely to sooner or later see huge movements in price, giving an opportunity to generate large profits.

As such, commodities should be especially interesting to longer-term traders who are prepared to hold a trade for weeks or even months.

Commodities can be traded successfully using technical analysis alone, but fundamental traders can find many tools to generate intelligent analysis of the major commodities. This can be easier work than trying to pick a handful of stocks from the thousands of publicly traded companies listed on major exchanges.

Commodities can be very volatile, so it is important for traders to carefully limit their risk by limiting position sizes. This can be very challenging for retail traders, as commodities futures and options are usually only available in minimum position sizes ranging from $5,000 to $100,000. The typically high volatility in these asset classes means that a typical losing trade can be hard to budget for without losing too much account equity. Commodity ETFs or their options can be a suitable solution for longer-term traders on a tight budget. Due to high overnight swap rates, commodity CFDs are more suitable for commodity day trading than long-term trading.

FAQs

What does a commodity trader do?

A commodity trader buys commodities in the hope of selling later when the price is higher or sells commodities (going short) in the hope of buying later when the price is lower, to generate cash profits.

How do I start trading commodities?

Educate yourself about commodities and consider the pros and cons or different commodity instruments and commodity trading strategies. The next step is to open a demo account and practice commodity trading for a few months before going live.

Is commodity trading better than stock trading?

Stock trading is cheaper, but commodity trading is easier to research.

Is commodity trading good for beginners?

The only reason commodity trading might be especially challenging for beginners are the very large price movements which are common in this asset class, which might be psychologically difficult. However, this can be managed by trading very small position sizes.

Adam Lemon

Adam Lemon began his role at DailyForex in 2013 when he was brought in as an in-house Chief Analyst. Adam trades Forex, stocks and other instruments in his own account. Adam believes that it is very possible for retail traders/investors to secure a positive return over time provided they limit their risks, follow trends, and persevere through short-term losing streaks – provided only reputable brokerages are used. He has previously worked within financial markets over a 12-year period, including 6 years with Merrill Lynch.
Learn more from Adam in his free lessons at FX Academy

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