The Interaction Between Fundamentals and Price in Commodities Markets
Commodity traders, for the most part, rely on the analysis of price movements to assess the desirability of entries and exits with their trades. While this sort of analysis may play a role in the activities of primary participants in the commodities markets, end users and suppliers tend to pay more attention to fundamental analysis, especially since they are often so well situated to do so from their more intimate knowledge of the commodities they deal in.
In a real sense, commodities markets are made more efficient by both the fundamental side of those who deal in the commodities and the technical side of commodities traders. If, for instance, there is a change in the fundamental outlook of a commodity over the life of the contract, this will find its way into prices by the actions of those who track these things.
This is actually the primary driver of commodity prices in the end, as fundamentals are the only thing left over when the dust settles in a contract, as the price will always gravitate to the spot price of the commodity at the conclusion of it, and spot prices are purely driven by fundamentals.
Within this time frame, the price of commodities are also driven by the supply and demand of the market, where speculators can both drive up the price of them and drive them down by their trades. In the end though, when the trading is done, this will not and cannot have an effect upon the closing price, since the spot market at the time will always determine this.
Commodity Traders Ride the Waves
Along the way, traders will look to ride changes in outlook driven by these fundamental forecasts, and this price action will therefore tend to be at least temporarily out of equilibrium, due to traders piling on and adding to this momentum.
This is the way all markets work though, and is certainly not peculiar to commodities markets, although the more fundamental nature of commodities markets tends to keep this in check more. Markets always seek equilibrium, although along the way there is a constant ebb and flow as prices rise and fall in excess of this on their journey.
Traders simply look to take advantage of these ebbs and flows, which exist on various time frames, as they always do with financial trading, and while these movements may not be all that significant in magnitude, they use leverage to make these trades worthwhile.
If the price therefore gets out of line as far as the fundamental outlook goes, those trading based upon fundamentals will jump in and bring it more in line. This is something that commodities traders need to understand, that there are some real limits here to momentum, and the limits are fundamental ones.
So, we won’t see the price of corn get bid up to $1000 a bushel or anything from market demand spikes, like we’ve seen for instance with cryptocurrencies, which have no fundamental basis whatsoever. Stocks do have a bit of fundamental basis, even though we’ve seen stocks with no earnings go sky high like what happened in the dot.com craze of the late 1990’s.
Therefore, when you are trading commodities, you need to realize that these limitations on price will cause the market to be limited in range, and the goal therefore of a good commodities trader is not to look to ride something too far but to instead be aware that there are real limits to moves in either direction.
How This Affects Commodities Trading
Commodities trading is therefore more range bound than most other forms of trading, and traders who are better at trading ranges, picking bottoms and tops essentially, are the ones that have the best chance of success.
Range based trading is more difficult than other forms of trading, for example looking to trade larger swings in stocks or indexes, where you may have a bull or bear market for extended periods, and you look to ride the trends.
There are always trends in markets, it’s just a matter of duration and magnitude, and trends of lesser duration and magnitude require more nimble trading.
The problem of trading on the wrong end of ranges that many amateur traders fall victim with, buying after a certain move and then seeing the move turn against them quickly, is even more of a concern with commodity markets, and one must be careful to avoid getting caught in these traps.
While limiting your risk exposure and therefore your losses per trade is important enough with other forms of trading, it is even more so with commodity trading, especially since it tends to be highly leveraged.
This leads to the tendency for traders to prefer shorter time frames, as the longer the time frame of the trade, the more risk it is exposed to. While commodities can see some big momentum moves at times, they also tend to be more choppy than many other types of trades, and the choppier the trade, the more nimble the trader needs to be.
The longer your outlook with a trade, the more room you have to give it, and the more range bound a market is, the less room you can afford to give it, because there is less room overall for the moves in general.
Within these constraints, there is still a fair bit of latitude with commodities, and you don’t just have to trade these markets minute by minute like some professionals do. It is possible to engage in longer term trading, where positions are held for days or even weeks, although more care needs to be exercised to not get stopped out too much but still provide enough safety.
The big appeal of commodities markets is the leverage you can get with them, and for skilled traders, this allows for their trading advantage to be multiplied by several times over what could be achieved with cash or the modest leverage available in the stock market or with exchange traded funds.
This leverage also allows for one to profitably trade much smaller moves than could be achieved otherwise, where the gains from them can be well in excess of trading costs, something that wouldn’t be the case if you are trading with cash or smaller leverage.
There’s a lot more trading that goes in in commodities markets due to this added leverage and it does benefit the market in general. This also serves to accelerate any disadvantage one may have though and traders who are uncertain of their skills need to exercise a lot of caution here.
Many don’t though, and will instead see themselves bust their accounts much more quickly than they otherwise would trading with a lot less leverage. Leverage is certainly a double-edged sword and you always want to be confident enough of what you are doing lest the sword be used on you.
There is a lot of money that can be made trading commodities provided that one has enough of an understanding of how to trade generally and how to adapt one’s trading to particular markets. There’s also a lot that can be lost as well and even some of the world’s best traders have paid the price here at one time, by not properly paying attention to risk management, and risk management is even more important here.
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
Areas of interest: News & updates from the Federal Reserve System, Investing, Commodities, Exchange Traded Funds & more.
