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The Pros and Cons of Commodity Trading

5paisa Research Team Date: 23 Mar, 2022 02:13 PM IST

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Introduction

Of late, online commodity trading has emerged as a viable alternative to capital market investments. The account opening process is like opening a stock market investment - what makes them different is how these financial instruments are traded. Unlike equity stocks, commodities are traded through spot, futures, and options contracts. Commodity prices depend on various factors, including geopolitical issues, government policies, demand or supply constraints, production factors, etc.

The benefits of commodity market investments include lower volatility, hedging against inflation or geopolitical events, diversification, etc. And, the disadvantages of commodity market trading include high leverage, excessive volatility, higher dependence on macroeconomic factors, etc.

The following sections talk about these points to help you make the correct decision while trading commodity online. But before heading further into the pros and cons of commodity trading, let's understand the meaning of the term 'commodity trading.'

What is Commodity Trading?

Commodity refers to things like metal (gold, silver), energy (gasoline, crude oil), food (cocoa, rice), and the likes. When these commodities exchange hands through commodity exchange, it is known as commodity trading. In India, exchanges like MCX (Multi Commodity Exchange of India Limited) and NCDEX (National Commodity and Derivatives Exchange Limited) oversee and control commodity market trading. To trade a commodity online, you need a Demat account and trading account.

Let us now discuss the benefits of commodity market investment and why sensible investors prefer online commodity trading.

The Top Benefits of Commodity Market Trading

Facilitates Diversification

The 21st-century investors are more informed. They know the various benefits of diversification. If you are unfamiliar with the term diversification, here's one line to simplify the concept - diversification refers to dividing your capital among several financial instruments to minimise the risks and maximise the returns.

Online commodity trading lets you diversify your investments well and reduce the risks of capital loss. Generally, commodities and stocks or bonds move in opposite directions. For example, if two countries suddenly get into a war, investors may feel apprehensive and withdraw their money from stocks or bonds and put them in safe commodities like gold or silver.

Conversely, if the economy performs well and companies display a sharp jump in profits, investors might dump gold or silver and move to equities. Hence, the presence of commodities in your portfolio can help you hedge your risks for maximising the profits.

Inflation

Inflation is a dreaded word for people buying physical commodities. However, if you are an online commodity trader, inflation might be your best friend. Inflation simply means an increase in the prices of commodities. So, if you hold a commodity whose price is increasing, your portfolio value will also increase. This ensures that your purchasing power remains the same even if the inflation rate is at its all-time high.

Stocks and bonds generally witness a fall when inflation rises since inflation often dries up the liquidity, reducing purchasing power.

Liquidity

Online commodity investments are 100% liquid since you can sell them anytime, making them a better option than real estate or fixed deposits. Like stocks, commodities are easy to buy and easy to sell. Hence, commodity derivatives can be a safe bet when you want better authority over your funds.
Now that you know the benefits of commodity market investment let us learn about the disadvantages of commodity market trading in the following section.

The Disadvantages of Commodity Market Trading

1. Leverage May Quickly Go Out of Hand

Online commodity traders typically get higher leverage than stock traders. However, higher leverage may also make it difficult to control the urge of overtrading. And if the market goes opposite to your calculations, you may lose money against winning it.

2. Excessive Volatility Might Confuse You

Back of the envelope calculations suggest that commodities are twice as volatile as stocks and four times more volatile than bonds. And, commodities such as crude oil, gold, etc., are more volatile than others. Such large price swings might make you lose focus and play havoc with your calculations.

3. More Exposed to Economic and Geopolitical Factors

Commodity prices depend on various economic and geopolitical factors. For example, if crude oil production increases, the commodity's price will drop and vice versa. Also, during the peak of the COVID-19 pandemic, crude oil prices dropped to rarely-seen-before levels. Hence, as an online commodity trader, you need to stay more informed about global political news and evaluate various macroeconomic data.

Should You Invest In Commodities?

Online commodity trading can open up a completely new avenue for you. Commodity trading is often considered more reliable than equity stocks. However, investors acquainted with stocks and sectors consider equity stocks more rewarding and easier to understand than commodities.

Hence, whether to invest in a commodity or not must be governed by your risk-taking ability and not emotions. 5paisa is the preferred broker of people willing to experience low-cost brokerage and precisive order execution. Click here to learn more.

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