Speculating on Commodities

The main way that traders speculate on commodity prices is through the futures market. Contracts to buy or sell lots of various commodities are traded on the open market, where people can hold these contracts for various periods of time.

Futures contracts are based upon agreements between producers and end users of commodities, consisting of contracts to buy and sell the commodity at a future date for a specified price. These contracts allow suppliers and users of commodities to benefit by knowing how much they will pay and how much they will receive for the commodity being contracted for.

Speculating on CommoditiesOne does not have to intend to supply or receive a commodity to buy or sell a commodities contract though, and most futures contracts these days do not involve people taking possession or supplying anything, as they are essentially bets on the future price of these contracts which are settled in cash.

Let’s say a business, a cereal producer we’ll say, wants to buy a certain amount of corn and take delivery in a few months, at the expiration of the contract. They will buy the contract and then exercise it at expiration, and receive the delivery of corn.

This is the hedging side of futures, and it does benefit companies to enter into these contracts because it allows them to know what they will pay or receive in these transactions in advance. This allows for better planning as well as looking to avoid larger price fluctuations which may present business difficulties.

Speculators, on the other hand, have no interest in taking delivery of, say, 100,000 gallons of gasoline. They could, and then sell it on the spot market to realize the difference, the profit or loss of the trade, but this would involve unnecessary transaction costs.

For instance, you could buy it from the producer and then sell it back to them and the producer would want to be compensated for this, so this would add to the costs of the trade and make the trading less desirable.

Instead, what we can do in this case is just settle the contract based upon the price differences itself, the difference between the price at expiry and the price on the spot market, if you were going to sell or buy the commodity, even though you are not.

Actual suppliers and users of commodities settle contracts this way sometimes as well, and it often is a more efficient way to settle things, to just transfer money. With the difference in hand, they can now buy the commodity they desire on the spot market.

Why People Speculate on Commodities

Commodity futures are a type of financial derivative, a security that is based upon the value of another asset. Derivatives are essentially side bets on an asset, and even the hedgers are placing side bets, and that’s all that futures contracts are actually.

If you want to buy a commodity in the future for instance, when you buy a futures contract, you are placing a bet that the price at the expiration of the contract will be higher than the price you paid for the contract. If it is, you win the bet by the amount that the price is higher than what you paid, and if it is lower, you lose the bet by that amount.

Since this is all just betting on commodity prices, and the value of the betting can be measured in cash at the end of the contracts, people not involved at all in commodities may want to make these bets as well.

As opposed to those who do produce and use commodities, the bets that speculators make do not have to be carried through to the end, as they can close out their positions at any time and take the profit or loss between what they paid and what the contract is currently worth on the market.

Traders do like to bet, and will bet on a lot of different things, and betting on commodity prices is a very popular way to bet. These are not randomly placed bets, and bets on securities do involve some sort of strategy, and the goal with commodity futures trading is similar to other securities trading, to look to discern and take advantage of movements in price of the instruments.

How Commodity Price Movements Are Determined

All markets for securities involve fluctuations in price that may follow certain patterns. Commodity speculators generally do not have much knowledge about the fundamentals that drive commodity prices, and this is subject to a lot of uncertainty anyway, which is why the most knowledgeable people, the users and suppliers, trade commodity contracts, to manage this uncertainty.

Speculators may know absolutely nothing about a commodity, but this really isn’t a handicap, as they trade on price and not underlying fundamentals. Whatever may influence a commodity is going to be priced into it anyway, how bullish or bearish the market is on it at any given time based upon the sum of all fundamental knowledge about it at present as well as predictions in the future about this.

There is another element that affects the prices of securities in general significantly, including commodity futures prices, and that is changes in the supply and demand of the security itself.

The goal in trading anything is to measure momentum one way or the other, in various time frames, and then look to ride that momentum with the expectation that the probability of it continuing for a time is high enough to create a positive expectation net of trading costs.

The tools of the trade here are charting and technical analysis, where traders look to see how the price of the contract has moved, where it is now, and where it may be at some future point.

If something is under accumulation for instance, demand will exceed supply for a time, and that will cause the price to rise. It doesn’t even matter why, it could be that companies are buying more contracts, a hedge fund taking a position, individual traders seeing the price going up and jumping on, whatever. It’s going up, and if it’s going up or down in a way that is predictable enough, we may be able to take advantage of this.

What distinguishes the futures market from other forms of trading such as the stock market is that there is no long-term bias to the futures market, as these are trades with a limited time scope and things all get settled eventually.

With the stock market for instance, prices of stocks tend to rise and therefore on the long side there is a net profit over time to investors. With futures, this is not the case, and every dollar made becomes offset by a dollar lost by someone else, whether this be with speculators or hedgers.

This can make things a little more challenging to trade commodities than with other things, even other futures contracts such as indices. It is the fact that the underlying asset, in this case the commodities, are going to settle, they don’t go up in value the same way that stocks do. So, in trading commodity futures, you are up against the other traders in the market directly, and therefore if someone is looking to become good at this, this is going to take more skill than normally is required.

With that said, smaller position traders do have some natural advantages over larger traders, simply due to the ease of entering and exiting positions, with a single click instead of a strategy of accumulation and distribution. However, one still needs to know what one is doing to do well at this once luck gets factored out, which will always happen over time.

Other Ways to Speculate on Commodities

Aside from commodity futures, there are a number of other ways that individual traders can trade commodity price fluctuations. One can buy stocks in commodity producers for instance, for instance gold mining companies, and while derivatives trading like futures is never a longer-term play, stocks can be depending on how long you want to hold them for. Any business whose performance is significantly driven by commodity prices, including users, can be traded based upon expectations of commodity prices.

Exchange traded commodities, or ETC’s, allow investors to buy or sell securities consisting of commodities, which are traded like stocks. ETCs are actually traded on stock exchanges, and may track a single commodity or a basket of them. The underlying commodities are held as collateral for the securities.

There are a number of exchange traded funds, or ETFs, that track commodities in various ways. ETFs are very flexible and may include commodities, commodity producers, or even simulate a a commodity directly. The benefit of ETFs is that they are both professionally managed and can be bought and sold on an exchange, as opposed to a mutual fund which is bought through dealers and one cannot trade them as often or with the same speed.

People will also buy and hold commodities, bullion for instance, and you can buy gold futures, a gold ETF, or you can just buy and hold the gold itself. Buying gold is a longer-term way to speculate on gold, and is often used as a hedge against stock market fluctuations, since it often moves inversely with stocks.

Commodities aren’t the easiest thing to trade, although many people do well with them. Successful trading does take quite a bit of skill, and commodities trading takes a little more, but there are both winners and losers here, and those who are dedicated enough to achieve the required mastery of these markets are certainly well rewarded.

Ken Stephens

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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