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A commodity is a basic good used in commerce that is interchangeable with other goods of the same type. Traditional examples of commodities include grains, gold, beef, oil, and natural gas.
For investors, commodities can be an important way to diversify their portfolio beyond traditional securities. Because the prices of commodities tend to move in opposition to stocks, some investors also rely on commodities during periods of market volatility.
In the past, commodities trading required significant amounts of time, money, and expertise, and was primarily limited to professional traders. Today, there are more options for participating in the commodity markets.
- Commodities that are traded are typically sorted into four broad categories: metal, energy, livestock and meat, and agricultural.
- For investors, commodities can be an important way to diversify their portfolio beyond traditional securities.
- In the most basic sense, commodities are known to be risky investment propositions because their market (supply and demand) is impacted by uncertainties that are difficult or impossible to predict, such as unusual weather patterns, epidemics, and disasters both natural and man-made.
- There are a number of ways to invest in commodities, such as futures contracts, options, and exchange-traded funds (ETFs).
A History of Commodities Trading
Trading commodities is an ancient profession with a longer history than the trading of stocks and bonds. The rise of many empires can be directly linked to their ability to create complex trading systems and facilitate the exchange of commodities.
In modern times, commodities are still exchanged throughout the world. A commodities exchange refers both to a physical location where the trading of commodities takes place and to legal entities that have been formed in order to enforce the rules for the trading of standardized commodity contracts and related investment products.
Some commodities exchanges have merged or gone out of business in recent years. The majority of exchanges carry a few different commodities, although some specialize in a single group. In the U.S., there is the Chicago Mercantile Exchange (CME), the New York Mercantile Exchange (NYMEX), the Intercontinental Exchange (ICE) in Atlanta, Georgia, and the Kansas City Board of Trade. In Europe, there is the London Metal Exchange (LME). As its name implies, the London Metal Exchange only deals with metals.
Special Characteristics of the Commodities Market
In the broadest sense, the basic principles of supply and demand are what drive the commodities markets. Changes in supply impact the demand; low supply equals higher prices. So, any major disruptions in the supply of a commodity, such as a widespread health issue that impacts cattle, can lead to a spike in the generally stable and predictable demand for livestock.
Global economic development and technological advances can also impact prices. For example, the emergence of China and India as significant manufacturing players (therefore demanding a higher volume of industrial metals) has contributed to the declining availability of metals, such as steel, for the rest of the world.
Using Mutual and Index Funds to Invest in Commodities
While you cannot use mutual funds to invest directly in commodities, mutual funds can be invested in stocks of companies involved in commodity-related industries, such as energy, agriculture, or mining. Like the stocks they invest in, the shares of the mutual fund may be impacted by factors other than the fluctuating prices of the commodity, including general stock market fluctuations and company-specific factors.
However, there are a small number of commodity index mutual funds that invest in futures contracts and commodity-linked derivative investments, and therefore provide investors with more direct exposure to commodity prices.
By investing in mutual funds, investors get the benefit of professional money management, added diversification, and liquidity. Unfortunately, sometimes management fees are high, and some of the funds may have sale charges.
Using Commodity Pools and Managed Futures to Invest in Commodities
A commodity pool operator (CPO) is a person (or limited partnership) that gathers money from investors and then combines it into one pool in order to invest that money in futures contracts and options. CPOs distribute periodic account statements, as well as annual financial reports. They are also required to keep strict records of all investors, transactions, and any additional pools they may be operating.
CPOs will usually employ a commodity trading advisor (CTA) to advise them on trading decisions for the pool. CTAs must be registered with the Commodity Futures Trading Commission (CFTC) and are usually required to get a background check before they can provide investment advice.23
Investors may decide to participate in a CPO because they have the added benefit of receiving professional advice from a CTA. In addition, a pooled structure provides more money and more opportunities for the manager to invest. If investors choose a closed fund, all investors will be required to contribute the same amount of money.
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