Investment in simple terms in purchasing something, that would fetch a profit in the future. There are various options available to invest in. The most popular ones being, share market, bonds, and commodity trading. Investment is completely different from saving. To be precise, investment involves risk.
The concept of commodity trading
A commodity is any tangible good that possesses a demand in the market. Using commodity as a medium of exchange, dates back to the barter system, when people used to buy goods and commodities in exchange for others. Initially, agricultural produces were used in commodity trading. Around the late 1840s, when commodity trading became more prominent, the Chicago Board of Trade was set up. By the 1960s, precious metals such as gold, silver, and platinum also became a part of commodity trading. During the 20th century, there were several commodity exchange boards in the United States.
Categories of commodity
All the commodities that are traded today can be put under five different categories.
- Energy: This includes all the raw materials that are used in the energy production sector. For example, crude oil and natural gas
- Grains: Most agricultural produces fall under this category. Staple food crops like rice, wheat and corn are included in this. Grains such as Soybean that are used in food processing industries also fall under this category. Cash crops like cotton, cashew and Jute are also components in grain commodity trading.
- Livestock: Meat from various livestock animals like goat and sheep are included in this. Animal fat and animal-based products also fall under this category.
- Metals: This includes precious metals like gold, silver and platinum. Apart from these metals like palladium, copper and aluminium are also traded.
- Other: This includes lumber and paper pulp Of all these goods the most traded goods are Crude oil, Steel, Soybean, iron, corn, gold, copper, aluminium and silver.
Players in commodity trading
The two important components in commodity trading are
A. Hedgers: These are industries that work on processing and refining the raw commodity to finished product. This includes oil refineries, mining industries, food processing industries, textile industries, etc., B.Speculators: This includes banks and individuals who trade commodities. Speculators are the investors, who make use of the fluctuating prices of commodities to earn a profit.
Factors that affect commodity trading
Several factors affect commodity trading. The price of commodities relies majorly on the climatic conditions. In the case of agricultural produces, the climate is a major factor affecting production. The transportation and shipping of goods across countries is also affected by the weather. Investors have to analyse in deep, the factors that affect commodity trading before investing. Weather is always unpredictable, and so is the commodity market. The fluctuating prices are usually unpredictable. Analysis and experience are the only ways with which an investor can gain benefits in commodity trading.
There are several commodity markets all around the world. Commodity markets work for buying and selling of all goods. But certain markets are specific to a particular type of commodity. For example, the London Metal Exchange (LME) exclusively deals with metal commodities.
Basis of commodity markets
Commodities are tangible goods. They are manufactured to usable products in later stages. The basic principle of the commodity market is a simple demand-supply relationship. When the supply is low, the demand for the product goes up. Along with the demand, the price of the product also shoots. When the supply is very high, the demand is less and so there is a fall in the price. The demand and supply vary according to various factors. For example, the sale of gold and other precious metals is very high during occasions. Especially during the wedding season in countries like India. During this season there is an increased demand for metals like gold, silver and platinum. These events can be predicted well in advance. So that the trader can decide when to buy and sell off his commodity. But there also occur unpredictable situations. This includes events like heavy rainfall or drought or unpredictable diseases. Traders dealing with agricultural and livestock produces will face a threat under such conditions.
When there is a crash in the stock market, investors usually rush to invest all their money in commodity trading, especially in precious metals. This is an alternative option to escape the stock market crisis. Investors also tend to invest in precious metals during currency devaluation to escape major losses.
Agricultural products are highly volatile. They also contribute very less to the commodity trading market. This includes food grains, livestock and cash crops. Very few investors take up this risk and work in these areas.
This is one major strategy in commodity trading. The futures contract is simply an agreement to buy or sell a particular quantity of a particular commodity at a specific price. The concept of a future contract is mainly done to normalise the cash flow by the industries. This is also done to avoid issues that are faced due to everyday changes in the pricing of these commodities. For example, the price of crude oil and natural gas keeps fluctuating with each passing day. But airlines fix prices for tickets months before the actual journey. In such cases, a futures contract will help the airlines fix the price.
The agriculture sector though unpredictable and highly volatile also works on a future contract idea. This is because the delivery of commodity takes time, especially in the case of oil and natural gas. Under such circumstances, future contract helps to avoid discrepancies between the buyer and seller due to the fluctuating prices.
The future market contract also has its disadvantages. This could result in either gain or loss for the seller. This is considered risky especially for investors who are new to the commodity market. A future trade planned, can go against your idea, leaving you in a loss.
Types of investments in commodity trading
There are four major trading options in the commodity market
- Direct investment: This is the simple commodity trading of particular commodities. It doesn’t involve complicated steps and procedures. If you are making a direct investment, the investor has to figure out where to sell and store the products. You also have to work on identifying a buyer and shipping of the commodity.
- Alternatively, future contract investments can help you handle the difficulty. This will help you escape the difficulty with varying prices.
- Yet another method is to buy shares of exchange-traded funds that specialise in commodities. This is a linking bridge between individual investors and large commodity producers.
- You can also invest in companies that produce these commodities. This includes production companies that work with the commodities. For example, an investor purchases shares of an oil exploration company. When the price of crude oil goes up, the company is benefitted. In turn, the value of the shares of the company also increases. The investor can also gain benefits in this way.
An investor can choose from these four options if they wish to invest in commodity trading. Trading requires risk-taking and decision-making skills. This will help the investor make the best out of the prevailing market conditions. This is true in case of commodity trading as well.