Updated on March 30, 2023
Seasoned investors worldwide agree that trading commodities play a significant role in balancing out a portfolio. However, for inexperienced investors, the concern would be comparing soft commodities vs. hard commodities. This article explores the two in-depth to show the merits, demerits, and characteristics of both.
What are commodities?
Commodities are physical raw materials that investors can trade on the commodities market. Although this definition focuses on natural resources, recently, the definition has expanded. The modern definition of commodities also includes financial and technology products like foreign currencies, indexes, cell phone minutes, and others. There are two broad categories of commodities: soft commodities and hard commodities.
These comprise agricultural products such as coffee, cotton, wheat, beans, and others. These natural resources are farmed on a large scale and then follow a systematic value chain that facilitates processing into different products the final consumer purchases.
Soft commodities dominate the futures market because farmers utilise financial instruments such as futures trading to lock in a desired commodity price. This is because soft commodities are prone to price volatility owning to many macro and micro economic factors. For instance, changes in weather patterns, seasons, and diseases can greatly impact the output produced by farmers and influence market prices.
Additionally, weather and seeding/ harvesting reports also influence decisions taken on the trading floor, thereby exerting pressure on the value of contracts.
These refer to metals or energy resources mined from the earth, processed, and sold to the final consumer. Hard commodities are at the core of a country’s economic health. In fact, economists often use these commodities’ prices to gauge the state of a nation’s economic strength. For instance, Venezuela, heavily dependent on its crude oil exports, faced a major political crisis and civil unrest when global crude oil prices dropped.
Hard commodities are further broken down into two
Metals: These include examples such as gold, silver, platinum, and copper. Investors favour metals Metals because they rely on their stable prices to hedge their portfolios. For example, many investors hold investments in gold, and these are used to store value during times of economic uncertainty.
Energy: This category includes examples such as crude oil, natural gas, and gasoline. Energy prices are highly volatile and therefore encourage speculation among traders. For instance, crude oil, whose production is dominated by the Organisation of Petroleum Exporting Countries (OPEC), prices are dependent on both local and international events.
How the commodity market works
Commodity markets facilitate the buying and selling of commodities through major commodity exchanges and brokers. Commodity prices are typically determined by various forces of demand and supply in conjunction with macroeconomic influences. As a result of the wide price fluctuations in commodity markets, industry players have to rely on different financial instruments.
Through these financial instruments, commodity traders can hedge their portfolios and thereby earn higher rewards. Additionally, like was mentioned earlier, high price fluctuations attract the opportunity for gains through speculation and arbitrage.
Commodity trading takes place in commodity markets that are regulated by commodity exchanges. For instance, the Commodity Futures Trading Commission (CFTC) regulates commodity futures and derivatives markets in the United States. The most popular exchanges include the New York Mercantile Exchange (NYMEX), the Chicago Mercantile Exchange (CME), and also the Chicago Board of Trade (CBOT). The London Metal Exchange and Tokyo Commodity Exchange are significant players at an international level.
Through these exchanges, commodity traders are given the opportunity to trade, reduce their risk exposure, and diversify their portfolios. Investors buy and sell commodities in the form of futures contracts, options, and exchange-traded funds.
Financial instruments for commodity trading
Through a futures contract, commodity traders can invest in a specific commodity without incurring the risks or trouble of physically storing the commodity themselves. A futures contract refers to an agreement between two players to exchange an asset at a specific price and quantity on a predetermined date. A futures contract is typically a standard contract that investors trade on the Chicago Mercantile Exchange (CME).
For instance, 1 corn futures contract can be equal to, say, 5000 bushels of corn. Therefore, imagine a trader purchasing a corn futures contract on the Chicago Mercantile Exchange (CME) to hedge against price volatility. If the corn prices increase, the value of the corn futures contract would also increase and vice versa. At the expiration of the contract term, the trader would either have to take physical possession of the corn or take an offsetting position on the contract. Trading futures is very complex and is therefore only suitable for sophisticated investors.
Mutual Fund or Exchange Traded Fund (ETF)
One of the easiest ways for inexperienced investors to access the commodity markets is through mutual funds or exchange-traded funds (ETFs). Like the futures contract, mutual funds and ETFs save the investor from incurring the risk of physically owning the commodity. In most cases, traders set up commodity mutual funds as partnerships, attracting additional tax reporting (if held in a taxable account). Therefore investors should carefully review the structure of their mutual fund to confirm their tax obligations.
Factors that influence commodity pricing
Supply and demand
This is one of the basic economic laws that govern the production and flow of goods in a free market economy. According to the laws of supply and demand, an increase in demand leads to an increase in supply. When supply is high, commodity prices typically drop as commodity producers look for ways to increase sales. Alternatively, when supply is low, commodity prices rise to capture the new value.
Many factors influence the production of commodities; both local and macroeconomic in nature. Commodity production can be influenced by various factors like climate and crop conditions, land productivity, trade agreements, taxes or subsidies, cost of labour and other inputs, and other factors.
Cost of production
There are various costs farmers and miners incur in the cultivation or mining of commodities. Costs such as labour, technology, taxes, and others are transferred to the final price incurred by the consumers. Therefore, higher costs of production result in higher commodity prices and vice versa.
A country’s economic growth level has an effect on the prices at which people sell commodities. Consumers in wealthy nations have the necessary purchasing power to influence the prices of commodities through their strong demand. On the other hand, commodity producers in developing countries are sometimes unable to purchase what is produced or extracted.
Advantages of trading commodities
Commodity trading through financial instruments like a futures contract offers investors liquidity. Traders enjoy the advantage of liquidity owing to the high number of participants in the commodity markets.
Commodity futures contracts carry a low deposit requirement making it easy for anyone to participate. Investors can buy futures contracts easily and enjoy participation in this vibrant industry.
Commodities offer commodity traders an excellent opportunity for hedging their portfolios. For investors whose portfolios have many risky investments, a great way to spread that risk is to buy a commodity futures contract or invest through mutual funds and ETFs.
Seasoned investors are always looking for opportunities to diversify their portfolios which commodity trading does. There are many different types of commodity mutual funds and ETFs offering diversity that range from the type of commodity down to the time frame within which the investment can be held. Commodity trading presents investors with many options to suit every investment appetite.
Commodities offer investors protection against inflation. Historically, commodities have faired better than other financial assets such as stocks and bonds. This feature attracts many investors, especially during times of economic uncertainty.
Commodity trading is one of the few times investors can take advantage of leverage. Since investors only need to deposit a small initial amount, they can use this feature to open larger positions despite not immediately having the finances on hand.
Risks associated with trading commodities
Commodity trading involves high levels of volatility owing to the vast number of both local and macroeconomic factors that influence commodity prices. Seasoned investors often advise commodity traders are often to keep up with local and global events to accurately position their trades.
Commodity traders hardly ever have early warning signs of impending doom when it comes to commodity trading. While certain scenarios, like the Russian invasion of Ukraine, could have been predicted by keen investors, others, such as the earthquake in Turkey, are simply random. This can make commodity trading intimidating, especially for inexperienced investors.
Inexperienced traders often have it worse than others because they don’t know what forces to keep track of. Although commodity trading offers many advantages, one must be a seasoned investor and trade with intelligence and caution to win big in this market.
In conclusion, a commodity trader must understand the key distinction between the two when considering soft commodities vs. hard commodities. Soft commodities are agricultural resources that farmers harvest and sale on a large scale. Hard commodities are mined or extracted from the earth. Both types of commodities are traded on the stock market and major commodity exchanges around the world. As a commodity trader, you must first hone your skills before diving into this volatile market.
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