Investing in commodities - motives and benefits.
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Skilling Writers Team
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- Commodities
- Trading
One of the earliest types of investment is commodity trade, which started as a barter, or the trading of goods or materials. The emergence of clay tokens from Mesopotamia, where the Sumerians used them to calculate the number of goats that would be delivered on a specific day, marks the beginning of futures contracts.
When making investments in raw materials during the Middle Ages, farmers sought to guarantee a future sale of their harvests. The buyer was certain that he would receive the products in the specified quantity at the predetermined price thanks to this method of obtaining future sales at a predetermined price.
However, in 1848, the Chicago Board of Trade was founded. It is currently one of the marketplaces that traders, institutions, and speculators frequent the most.
What does investing in raw materials entail?
Investing in raw material commodities is a form of trading that involves speculation and investment on the commodity markets. Raw material commodities can be anything from commodities like wheat, oil, gold, silver as well as some agricultural products. The goal of investing in commodities is to generate profits by accurately predicting whether prices will move in either an increasing or decreasing direction.
This kind of trading provides investors with opportunities for large potential gains, but also carries with it risks due to fluctuating prices. Investors look for signals on whether to buy or sell commodities which could arise from political issues, natural disasters or similar market-influencing events.
The primary distinction between raw materials and other products is one of standardisation. This means that regardless of who produced the raw material or where it was produced, each unit of the finished product will have roughly the same quality and cost. Therefore, whether cotton is produced in Vietnam, Brazil, or India, its price will be the same at 1,000 grams.
Forms of investment
Here are the most well-liked investment options available if you wish to start making investments in raw materials:
- CFD trading:
In this instance, you speculate on changes in the price of the chosen raw materials. Despite not owning the raw material, the derivative that perfectly matches its trajectory will allow us to trade it on the financial market. - Purchasing stock in a mining or oil company:
This is a direct method of commodity investment. By purchasing shares, you acquire ownership of the business and turn into a shareholder. - Purchase option or futures contracts:
These contracts give you the option to buy or sell a commodity at a predetermined price in the future. Option contracts allow you - but do not oblige you - to choose whether to buy or sell a commodity. - Investment in exchange-traded funds (ETFs):
There are a number of ETFs that are invested in raw materials. ETFs are funds that mimic the performance of an index. It is simpler and more indirect to invest in commodities in this way.
Types of commodities:
When investing in commodities, it is useful to know that they are classified in two groups: hard commodities and soft commodities.
Hard commodities are mostly those that are extracted (such as gold, oil, etc), while soft commodities are agricultural or animal goods (wheat, cotton, soybean, sugar etc).
The two above groups are also broken down further into:
- Agricultural products: this category covers unprocessed goods like sugar, soya, coffee beans, etc.
- Energy items include gasoline, electricity, and oils like WTI or Brent.
- Metals: This category contains both base metals like copper as well as precious metals like gold, silver, and platinum.
- Livestock Products: These include various meat products, as well as pig and cattle guts.
Top commodities traded in history
Throughout history, top commodities have been extremely important factors in driving economies and commerce. Gold, silver and oil top the list of famous commodities that have been commonly traded for centuries. Gold has had its place as currency as far back as ancient civilizations, with large deposits found all over the world.
Silver is another mineral that has formed the backbone of some societies' economies and continues to be widely used today in jewellery, coins and even electronics. Oil has also transformed how worlds operate, it being a major source of fuel and motor energy. In addition to these three major top commodities, cotton, wheat and livestock have all featured abundantly in trading activities down the ages.
It is clear then, that top commodities such as gold, silver and oil have had a powerful impact on the fate of entire nations throughout history until present day.
Let’s explore these in more detail:
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Gold
For many years, gold has been a sought-after commodity. This is mostly because of gold's relatively low price volatility, high level of liquidity, and reputation as a reliable store of value.
Contrary to most other commodities, supply and demand is not the primary factor influencing the price of gold. The amount of metal in the globe keeps increasing since once gold is mined, it won't vanish and little of it is used. Gold has been used as the perfect metal for making coins throughout human history, though gold coins are now very uncommon.
Over the years, the gold standard has had a significant impact on monetary systems, with several nations tying their currencies to the price of the metal. Many countries have also kept significant reserves of the precious metal as a form of insurance against potential increases in inflation or currency devaluation. Because of all of these considerations, the price of gold is one of the financial markets' most closely watched indicators.
Silver
Since ancient times, silver, a precious metal, has been used as money. Today, silver is traded on international financial exchanges. The erratic nature of silver pricing makes it a desirable commodity for those seeking quick gains.
When compared to markets for other commodities like gold or crude oil, silver is very modest. This implies that wealthy investors may have more ability to manipulate silver prices. Nevertheless, if you know what you're doing, trading silver could be beneficial.
Each ounce of silver is valued at US dollars (oz). The most popular silver CFD, tracking silver's price against the US dollar, is XAG/USD.
Oil brent and WTI
Crude oil and brent oil are both commonly used in the global energy market. Crude oil is a naturally occurring liquid fossil fuel that typically originates from either Europe, Africa or North America. Brent crude in comparison is a light crude oil sourced from the North Sea that was named after Brent Goose because of its abundance on the coast off Northern Scotland during the crude's formation millions of years ago.
Both crude oils have significant disparities between them, including viscosity, sulfur content and wax deposits. They are used for different purposes such as manufacturing and trading markets due to their unique properties. Brent crude has been an important factor in commodity trading since it began in 1988 and is considered by experts to be one of the most actively traded crude oils in the world today.
Cotton
Another common soft commodity traded is cotton. It is obtained as a soft fibre from the seeds of the Gossypium genus of plants. The most typical locations for this kind of plant are India, Africa, Australia, and Mexico. Currently, about 25 million tonnes of cotton are produced each year.
In the textile and apparel industries, cotton has grown in value. Since ancient times, cotton fibres have been twisted into clothes. The role of cotton in the garment business was then greatly enhanced by the Industrial Revolution, with the global market for woven and knitted cotton reaching multi-billion dollar levels. The cotton plant has evolved into more than just apparel.
Benefits of investing in commodities
Being unique assets that won't mimic the development of any index is the main benefit of investing in raw materials. Another benefit is the wide range of raw materials that can be used to operate, even within the same market.
Volatility is the biggest drawback of investing in commodities. Due to the frequent price fluctuations, commodities make for risky investments. Another drawback to consider is that because of the market's volatility, speculative fluctuations are significantly more pronounced than on other markets.
Except for gold, which, due to its stability as an investment value, is frequently utilized even as a defensive position during financial crises, often referred to as a safe haven.
A safe haven is an investment that is designed to protect an individual or institution from market volatility. These generally come in two forms:
- Physical safe havens such as gold or other precious metals, which can often be bought and sold as a physical asset
- And trading safe havens such as currency or bonds, which are investments that do not fluctuate with the stock market.
Both types of safe havens are good for hedging against market downturns and protecting an individual’s assets from economic turmoil. In times of volatility, safe havens provide some security from the risk of losses caused by changing markets and the instability of stocks.
Motives to invest in commodities
Commodities investment can be done for a number of reasons, but there are three key ones that make it an appealing proposition for traders. These include the expanding global population, protecting against inflation, and portfolio diversification.
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- Inflation defence
- The ability to avoid inflation is one benefit of investing in commodities. Because of inflation, which is defined as the rate at which prices increase, money now will be worth less in the future. This implies that in the future, more money will be needed to purchase the same quantity of a certain commodity in the context of commodity trading.
However, traders can safeguard themselves from these price increases and might profit from selling commodities at a higher price in the future by directly investing in commodities. - Population expansion
- At the turn of the 20th century, global population growth took off and has since grown to 7.7 billion people. The yearly growth rate is reducing, but it is still close to 1%, so the number will keep increasing.
Infrastructure demand is increased by population growth, which may have a substantial effect on the demand for energy and metals. Additionally, since there are more people, there are more mouths to feed, which will impact the demand for agricultural goods. - Increase portfolio diversity
- A portfolio that is well-diversified is uncommon among investors. The majority of a household's net worth is based on their property in many Western nations. Those who do invest frequently do so in equities or bonds.
The issue with this is that your portfolio will suffer significantly if the market you're investing in is heading downward (for instance, if the housing or stock markets decline). On the other hand, if you have invested in a variety of assets, your individual investments in markets that are declining will be impacted, but your total portfolio will be sheltered because other markets are flat or may even grow.
Consider commodity investing as a technique to increase diversity and improve risk management.
Costs of commodity trading
It is crucial to remember that your profit when trading CFDs on commodities is not just the difference between the opening and closing prices of the deal; you also need to take the trade's costs into account.
Three possible costs in commodities trading should be taken into account:
- Spreads. The spread is the distinction between a financial instrument's buying price (bid) and sale price (ask). You will need to go above this spread in order for a transaction to be lucrative.
- Swaps. A charge or adjustment is applied at the end of the day in the platform's time zone if you keep trades open over the course of the night.
- Commissions. A commission is also levied for starting and closing deals on some instruments.
As a final note, it’s also important to consider the role leverage plays in commodity trading as it allows traders to increase their exposure and potential gains with the same capital.
However, the increased risk it brings comes with a higher potential for losses. It's important that commodity traders have a thorough understanding of both its benefits and drawbacks to maximise their trading results. Leverage also affects commodity spreads and swaps, meaning it's essential to have knowledge of these instruments when making speculative trades.
Ultimately, leverage can be an invaluable tool when deployed correctly, but knowing its pitfalls is just as important as leveraging its power.
Not investment advice. Past performance does not guarantee or predict future performance.
