Introduction to financial markets
Commodities are the building blocks of the global economy – and can be an exciting asset class to trade. In this lesson, we learn more about how the market works.
What is commodities trading?
Commodities trading is the act of speculating on the price movement of raw materials and natural resources. These commodities are mass-produced and have practical uses, with their values relating directly to the demand we have for them in our society.
For instance, commodities can be goods like coffee that we consume, precious metals that are diverse and can be used for many different purposes or fossil fuels that are instrumental in fuelling the global economy.
They are split up into two groups: soft and hard commodities.
- Soft commodities are agricultural products such as coffee, soy and corn
- Hard commodities are natural resources such as gold or oil
Defining a commodity
To be classed as a commodity, an asset has to be fungible, which means an amount of the physical asset can be exchanged with an identical amount of the same asset without gaining or losing anything. One bar of gold, for example, can be swapped with another bar of gold.
If a commodity isn’t fungible, then it’s too hard to trade on the commodity markets.
How does the commodity market work?
Commodity markets work on exchanges, like stocks. However, instead of trading the commodities themselves, most buying and selling take place via futures – derivatives that enable speculators to trade on commodity prices without taking delivery of huge amounts of assets.
You can still buy and sell commodities for delivery today, using the spot market. But trading them online to make money has become much more popular.
What are commodity futures?
Commodity futures are contracts that give the buyer the obligation to trade an asset (such as oil or gold) for a set price on a set date in the future. Whatever happens to the asset’s price in the meantime, you’ll still pay the pre-agreed upon price.
Say you buy a future to trade gold at 1,800 in three months’ time. When the future expires, gold’s price is 1,900 – so your future enables you to buy it for a $100 discount.
Most futures contracts today are settled in cash. So instead of buying gold for 1,800 to profit from your future, the future seller would just pay you the $100 directly. By buying the future, you’ve taken a long position on gold without ever owning the underlying asset itself.
Commodity spot markets
Unlike futures, spot markets are settled at the current price for immediate exchange.
Because futures markets are settled on an upcoming date, their prices are always forward-looking. Spot markets, on the other hand, tell you precisely how much it would cost to trade a commodity today.
Types of commodities
Here’s a guide to main commodity markets:
Markets like Brent and West Texas Intermediate (WTI) crude oil are two major commodity markets and are seen as benchmarks in the oil industry. These markets are influenced by geopolitical events like international conflicts that can interrupt the supply of these commodities.
Oil benchmarks tend to see a lot of volatility. During the coronavirus pandemic, for instance, global demand for oil fell drastically. This fall in demand saw oil prices reach all-time lows.
- Precious metals
Precious metals such as gold and silver have held an intrinsic value in society for thousands of years and are now seen as ‘safe-haven’ assets. This means traders invest in these during times of volatility to protect the value of their portfolios.
Precious metals also have correlations to specific markets. For example, AUD is correlated to gold because Australia is a large producer of precious metals.
Agricultural markets are food or natural resources like cotton and lumber that are produced on farms or plantations. These resources have many practical uses in our society and for that reason are valuable, sought-after goods.
There are many different agricultural markets, such as sugar, corn, wheat, soy, lumber, corn and even live cattle. These markets have a heavy reliance on weather conditions in order to produce a strong harvest. As such, price volatility can depend heavily on seasonality factors.
What moves commodities?
The main basis of any commodity price movement is supply and demand. To trade commodities successfully, it’s important to understand how supply and demand can be affected so you can try to anticipate and predict how the markets might react.
The following factors are significant in influencing the supply and demand for commodities and can subsequently have a huge bearing on commodity price moves:
- Geopolitical instability
- The global economy
Commodities are exposed to environmental issues that can impact supply and have the potential to significantly impact commodity prices. These are often difficult to accurately foresee. An example with agricultural markets is if one time of the year is wetter than usual or warmer than expected, then prices will move as the market tries to adapt to how the supply will be affected.
Geopolitical instability has the potential to impact many markets, but commodities often feel the effect more than others.
For example, a large amount of the world’s oil is produced in the Middle East, with Saudi Arabia alone contributing to over 12% of global oil production. When oil bases in Saudi Arabia were attacked in 2019, oil prices rose immediately, with consumers anticipating a disruption to supply.
The global economy
Commodities are valuable resources in economies worldwide. Oils are used to fuel our transport, precious metals are used heavily in industries and crops like wheat are a vital food resource.
When an economy is growing, there will naturally be more demand for these resources. However, the supply of these is often limited for various reasons. For instance, poor weather can reduce the supply of crops, and natural fossil fuels and precious metals are finite resources. As such, if global economic demand is high, this can cause the prices of these commodities to rise.