From Stocks to Commodities: Navigating Trading Products

Trading means buying and selling assets like stocks or commodities to try and make money on changing prices. Stocks let traders own part of a company. Stocks go up or down based on how the company is doing and how investors feel about it. Commodities are basic goods that are produced and sold, like oil, metals, grains, or coffee beans. Commodities work a bit differently than stocks:

• Commodities are physical things that get used up. Stocks just represent ownership in a business. This gives commodities value for real-world use.
• Many commodities have limited supply based on what gets produced. Companies can keep issuing more stocks. Limited availability makes commodities potentially scarce.
• Commodity prices change more quickly than stock prices since supply and demand can shift a lot. Bad weather, transport issues, or problems at a mine can all rapidly affect prices.
• Commodities maintain their value better over time compared to money or financial assets. This makes them a good hedge against inflation.

Four Main Commodity Sectors

Commodities generally fall into four main sectors:

Energy - This includes oil, natural gas, gasoline, and coal. Energy prices depend a lot on global supply and demand. Disruptions anywhere impact prices everywhere.

Metals - Major metals like gold, silver, copper, and platinum trade actively. Their prices go up and down with economic growth and with worries about financial stability.

Agriculture - This covers grains like corn, wheat and soybeans plus livestock like cattle and hogs. Farm production and crop yields heavily influence prices.

Soft Commodities - Things like coffee, sugar, cocoa and cotton are called soft commodities. Their supplies often depend on weather conditions in a few key nations that produce them.

Of these, energy and metals make up most commodity trading volume. But agricultural commodities are important too and offer their own opportunities.

Trading Commodities Without Handling the Physical Goods

There are several ways to gain exposure to commodities without having to directly handle barrels of oil or bushels of grains:

Futures contracts - These are agreements to buy or sell the commodity for a set price at a future date. Futures trade on exchanges like the Chicago Mercantile Exchange (CME).

ETFs - Exchange-traded funds hold baskets of commodity futures contracts but trade like regular stocks. This provides easy exposure for investors.

Options - Options give the right but not the obligation to buy or sell the commodity before a set expiration date at a chosen strike price. Options allow leveraged bets on price direction.

Company stocks - Shares of commodity producers offer indirect exposure. For example, oil company stocks often follow the price of oil.

Futures and options provide a direct way to trade commodities but beginners may want to start with ETFs for simplicity. Advanced traders use options and futures for maximum risk/reward.

Common Trading Strategies

Skilled traders use various strategies to try to profit from commodity price moves:

Trend following - Identify the overall market direction using moving averages and make buys/sells based on the trend staying in force or reversing.

Spread trading - Take advantage of price differences between two related commodities, like buying gold and selling silver.

Seasonal patterns - Some commodities follow seasonal supply/demand cycles, like heating oil rising ahead of winter.

Carry trading - Sell short-term futures and buy longer-term futures to profit from pricing differences along the maturity curve.

Avoid Common Mistakes

It’s easy for newcomers to make miscues when trading commodities. Watch out for these typical errors:

Overleveraging - Using too much borrowed money is dangerous with volatile commodities. Avoid this temptation.

Fighting trends - Assume a trend will continue, rather than trying to call reversals prematurely.

Overtrading - Do not make too many trades at once. Patience pays off in commodities trading.

Ignoring stop losses - Always use stop losses to contain losses. Giving losses too much room to grow will backfire.

Commodities as an Inflation Hedge

With inflation recently reaching multi-decade highs, commodities have become popular again as a way to hedge inflation:

Usage value - Commodities have real-world usage value for production, manufacturing, food, and energy needs - giving them intrinsic value.

Limited supply - Unlike money, the amount of commodities cannot be freely expanded. Existing supplies are finite, which supports prices when demand increases against limited supply.

Inelastic demand - People and businesses need certain basic commodities regardless of price, within reason. This supports their value.

Rising costs - Higher commodity input costs for businesses tend to pass through into consumer price inflation. This supports overall commodity prices rising with inflation.

Not all commodities work equally well as inflation hedges. Core commodities with consistent demand like crude oil, grains, gold and silver tend to be better choices.

During past inflationary periods like the 1970s, commodities significantly outperformed stocks:

- 1970s - Major commodity price spikes occurred, while stocks struggled due to economic instability.

- 2000s - Commodities surged early in the period before crashing during the financial crisis.

- 2010s - Disinflation took over and stimulus boosted financial assets more than commodities.

Investors can benefit when inflation returns by keeping some commodities in their portfolio. Commodities provide diversification from stocks, which can be overvalued during bubbles. Their real physical value puts a floor under excessive speculation in financial markets.

Conclusion

Trading commodities offers different opportunities compared to trading regular stocks. Commodities have real usage value for things like energy, food, and manufacturing.

New commodity traders would benefit from taking things slowly. Start by reading books and taking online courses to build knowledge. Discuss commodities with experienced investors to gain insights. Start trading small amounts by using ETFs to gain exposure instead of holding futures contracts directly. Avoid jumping into options before having a solid grasp of movements in the underlying commodity prices.

Stay disciplined by using stop losses on every trade and limiting position sizes and leverage usage. Don't fight trends or overtrade. Stick to a smart trading plan.

While commodities carry risks, they also provide portfolio diversity. Commodities have often done well during high inflationary periods when stocks struggle. Their real-world usage value holds up when financial assets become overvalued. Maintaining some commodity exposure can lead to long-term inflation protection.