For a well-diversified portfolio, investors trade in commodities and benefit from their ever-changing economic cycles. However, commodity trading requires specialized knowledge and comes with higher risks than other forms of investments. Before starting, here are a few important things to know:
What Are Commodities?
Any natural resources like iron ore, agricultural products, fossil fuels, precious metals are classified as commodities in an economy. Commodities can be sold, bought, or traded, in contrast to stocks and bonds, which exist only as financial contracts.
Prices of commodities constantly shift as per the supply and demand chain of a single economy. If India faces a draught-like situation, the prices of grains are going to see a spike in the Indian economy. Similarly, if the production of oil increases in the Middle East, the price of oil will decline globally.
Investors who trade in the commodity market seek to profit from the supply and demand trends. At the same time, they mitigate risks through diversification by adding different asset classes to their portfolio. The real benefit of trading in commodity is the potential to protect your investments against inflation. Another advantage is the differentiated exposure received from the stock market.
Types of Commodities Trading
Trades can incorporate commodities into their portfolios in a few different ways, and each has its advantages and disadvantages.
The most common way to trading in commodity is through a futures contract. In which the investor agrees with another investor regarding the future price of the commodity.
Investors need to set up a speciality broker account to invest in futures trading that enables future and options trades. Whenever you open or close a position, the brokerage firm levies a commodity future trading commission.
In futures contracts, investors are not buying or selling the actual commodity itself. Instead, they are simply betting on the price changes. However, when it comes to precious metals like gold, silver, and platinum, investors can and do actually possess the physical commodity in the form of jewellery, gold coins, or bars.
While these trades allow you to feel the actual weight of your investments, precious metals are associated with higher transactional costs than other investment options. Investing in physical commodities is only practical if there are value-dense commodities involved. Even then, investors need to pay high markups on top of the spot price available in the retail market.
Another way to trade in commodities is to buy the company's stock that deals in that particular commodity. For example, if you wish to invest in oil, you could buy the stocks of an oil refining company. The way this works is that the stocks of these companies follow the price of the actual commodity. Theoretically, when oil price sees a spike, an oil company should be profitable as well. As a result, its stock price should go up too.
Investing in stocks is less risky than investing directly in the commodity because you are not betting your entire money on one commodity price. A well-established company could still make profits even if the price of the commodity is going down.
However, this could end up either way. Even though rising oil prices can benefit an oil company's stock price, its internal management and total market share are important factors. If an investor wishes to track a commodity's price precisely, investing in company stocks would not be the way to go.
Commodity Trading vs Stock Market
Leverage is more common in the commodity market than stock trading. Using leverage means investors only need to deposit a certain percentage of the money they need for investment.
A futures contract requires investors to maintain a minimum balance depending on the expected value of trade. If the market progresses in the direction where there's a potential loss, the investor faces a margin call. At this point, they are required to bring back the trade's required minimum value by depositing more capital.
Trading on margin can likely bring in greater returns than what the stock market has to offer. However, it can also result in equally great losses since leverage has been used.
Trading in commodity is a short-term investment, especially if the futures contract comes with an expiry. A stock market is where investors buy and hold their assets for a longer period.
Since the commodity market is open 24/7, investors have more time to make trades. The stock market operates during business hours only when the stock exchanges are open.
Compared to the stock market, commodity trading is highly unpredictable and risky. However, commodity trading can also fetch larger and faster gains if your positions end up in profits.
The Bottom Line
As an investment strategy, commodity trading is best suited for sophisticated investors. Since the shifts in commodity prices can lead to huge profits or losses, investors need to have a high appetite for risk. They need to be okay facing short-term losses in the sight of long-term gains.
Even if they decide to trade in commodities, only a portion of their entire portfolio should be allocated. Investors who usually wish to diversify in an asset class use only 20% or less of their portfolio towards a greater risk/reward profile. This is the actual segment where commodity trading thrives.