Fundamental analysis concerns itself with seeking to measure and predict forces which may affect the future supply and demand of a commodity or whatever instrument it seeks to become involved with.
While fundamental analysis plays a limited role in trading in general, with traders almost exclusively focused on measuring price trends, commodity markets do tend to incorporate significant amount of fundamental analysis in its trading.
There are some who think that trading commodities requires at least some form of fundamental analysis to be successful at it. Others may even feel that trading commodities successfully requires that we purely focus on fundamentals, although this view doesn’t really appreciate how markets work, how trading momentum itself drives price.
In a real sense, all trading, and even all forms of speculating, involve an attempt to correctly predict the future, or to do so correctly more times than not, to the extent that a profit may be realized out of one’s predictions.
If one is trading in commodities, whose prices are ultimately based upon not just the trading of securities like some financial assets such as stocks are, it is only natural to look to the underlying market itself, and look to predict changes in its behavior, the future relationships of its supply and demand.
There is in fact no other traded asset where fundamentals are so central to its ultimate price, and short of fraudulent manipulation of commodity markets by market participants, which we do see from time to time, fundamentals do play a big role in the ultimate value of commodity trades.
If the contract to trade commodities is to be executed at some point in the future, as is generally the case with most commodity trading, then the supply and demand of the trading will play a role as well, where what we could consider the equilibrium price based upon the fundamentals can be deviated from in various magnitudes for various periods of time.
How Fundamentals Influence Price With Future Dated Contracts
The spot market for commodities is of course purely based upon fundamentals, it is a direct product of the supply and demand for the commodity itself. While earlier on, prices will be set by a combination of the future expectation of price at the end of the contract along with the excursions from this that trading momentum provides, it is easy to see that fundamental analysis serves a primary role in determining the price of a commodity throughout the life of the contract.
While traders may bid the price of a commodity up or down to a certain extent, this will always be limited to what prices the commodity may bear, and therefore there are strict limits on this. For the most part, changing commodity prices during the life of commodity contracts reflect more the changing expectations of the future value of the commodity than any trading based excursions do, in spite of the fact that only a fairly small percentage of commodity contracts ever get exercised.
This is because the ultimate value of the contract will always have to correspond very closely to the spot price of the commodity at expiration, and while we may deviate from this along the way, this will always be done in reference to what the fundamental supply and demand may be. The goal is to look to predict that ultimately, and we become rewarded by doing so more accurately than not.
Traders can and do take advantages of fluctuations in the supply and demand of the contract itself, and depending on the time frame of the trade, if one is only focused on shorter term time frames, well short of expiration, these fluctuations can certainly be capitalized on.
Commodity prices change minute by minute and even second by second, and these fluctuations occur during periods where no new information has been introduced, so these excursions can be said to be to a large extent a product of the supply and demand of the contracts themselves.
So while commodity prices can deviate from what we may consider an equilibrium based upon fundamental supply and demand, this equilibrium does persist, even though not in a way that is an exacting one. This does provide opportunities for traders to capitalize on these disequilibrium if you will, where one can ride the wave to and from these theoretical values.
In spite of how prominent a role fundamental analysis is in commodity markets, being able to predict how it will change successfully enough is a different matter. Commodity markets have no issues at all with what we could call insider trading, and the trading of primary participants, those who actually produce or use the commodities, tends to be based upon a more intimate knowledge of the supply and demand for the commodity than speculators would generally have access to.
There are some people who think that, through what amounts to cursory attempts at fundamental analysis, that they can outsmart the market and come up with trading ideas based upon their analysis that will work overall, but this thinking is for the most part flawed.
When we trade commodities, we are going up against some very big companies, which not only include end users and producers of commodities, but large institutional investors as well. You can bet that these participants have much more expertise, knowledge, and resources than individual traders to be able to perform fundamental analysis and use it to their advantage.
If the market believes one thing, and you have ideas about something else happening, and you need to be right more than you are wrong, then you better have some very good ideas. While this all does not exclude the possibility of individual traders using fundamental analysis to outsmart commodity markets, this is at the very least an extremely difficult proposition.
There is also the matter of the current state of fundamental knowledge about the market already being priced in, or more correctly, in the process of being priced in. Since positions are built by large traders over time, it’s never really the case that what we know is already factored into current prices of commodities, and positions can take days or weeks to be fully deployed.
If not for this, the opportunities for smaller, individual traders would be much more limited. If a large traders whose outlook changed based upon new information executed all of their orders at once, commodity markets would be in a sense more efficient, but also far more volatile, where the fills would be far worse than what could have been obtained if large orders were executed with more patience.
How Smaller Traders Can Capitalize on Changes in Fundamentals
It is the big money that primarily drives all markets, where their positions do influence price considerably, although they wisely choose to trade more patiently, looking to minimize these effects.
Along the way, traders may look to capitalize on this. If these price adjustments occurred at once, without warning, this would not be possible. For instance, if the price of a commodity is at $1 and due to changes in fundamentals it should instead be valued at $.90, most of the time this change will occur over a period of time, as positions are entered and exited.
In this way, smaller traders can indeed look to take advantage of fundamental knowledge in the market, not by looking to discover it, but instead by looking to discover when the market itself is suggesting a change in beliefs.
This strategy is similar but separate from purely technical analysis, as it seeks to discern not where the price is trending, but rather, when prices are trending significantly due to large accumulation or distribution of contracts.
Looking to take advantage of larger market moves, and leaving the smaller ones alone, is a strategy that some traders use, and it is one that can be executed successfully provided one is skilled enough to be able to tell the real moves from the less significant ones, along with the patience to wait for them.
This is a strategy that can be used in most markets, any time there is large moves that take time to manifest, although the moves themselves may be of fairly short duration and this does require that traders be pretty active in commodity markets to spot them. It also requires a fair bit of skill and experience and this is not something that new traders can expect much from.
The most important thing to understand though when considering trading commodities with fundamental analysis is that you really need to be realistic about what you can bring to the table, aside from the current state of knowledge that is already incorporated in these markets.
Otherwise, traders may not only be wasting their time mulling over fundamentals, they may also be acting upon information that isn’t really reliable. Even if one looks to combine fundamental analysis of commodities with sound technical analysis, if our fundamental outlook isn’t on point, we run the risk of having this information distort our market outlooks and often cause us to trade with ideas that don’t work that well.
Commodities markets are completely zero sum apart from transaction costs, where one’s wins are always offset by a corresponding loss by another party. Smaller, individual investors do have some real advantages over larger ones, mostly due to the much smaller size of their trades, which allows them to trade more nimbly.
This only works if one both trades nimbly and with real skill, and both are required. While looking to determine the impact of fundamentals on commodity markets can be profitable, the best approach is to look to do so by looking at movements in price itself, which makes this analysis much more technical ultimately than fundamental.
Chief Editor, MarketReview.com
Ken has a way of making even the most complex of ideas in finance simple enough to understand by all and looks to take every topic to a higher level.
Contact Ken: ken@marketreview.com
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