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Learn to Invest

Investing In Commodities

By Kevin Johnston on April 6, 2022

Reading Time: 4 minutes

Investing in commodities can seem a bit exotic to the average trader. But it is easy to get into it and learn to trade profitably. Commodities can be a good way to invest in something besides stocks, bonds, and real estate. Learn the ins and outs of commodities trading, and you may expand your approach to making money in the markets.

Key Takeaways

How commodities are traded

What drives commodity prices

Simple ways of investing in commodities


The secret about owning commodities

The secret is that you never actually take possession of any commodity you buy. Instead, you won a contract to buy or sell the commodity. (The people who own actual commodities are buyers at big companies such as a manufacturer that needs raw materials to make a product.)

You will hear the word “derivatives” regarding commodities contracts. A derivative is a contract between buyers and sellers that gets its value from an underlying asset. So, as the commodity itself rises and falls in value, the contract you own on that commodity will rise and fall in value.

You are trading the contract rather than the actual commodity, so the contract is called a “derivative.” In actual commodity trading, “derivative” doesn’t come up much. Just think of it as a commodities contract.

How contracts change in value

Let’s say you have a contract to buy or sell a commodity at a given price on a specific date.

For example, if you own a contract to buy oil at $90 per barrel and the price of oil rises to $100 per barrel, your contract goes up in value. People would rather be able to buy at $90 instead of the $100 the market is demanding. So they will pay a premium for your contract. Or, you can buy the oil at $90-using your purchase contract- and sell it for the current price of $100.

If you own a contract to sell soybeans at $17 per bushel and the price of soybeans drops to $15 per bushel, you can buy at the current lower price of $15 and use your contract to sell at the $17 price.

In both of the above examples, you can also sell your contract. It has increased value because of the built-in profit.

What influences the price of  commodities

Investing in commodities can be profiitable

Commodities are subject to the influence of supply and demand. When the supply increases above the demand, prices go down. Sellers keep lowering the price to attract buyers. When demand is higher than supply, prices go up. The commodity is scarcer, and sellers raise prices.

The trick lies in understanding the factors that increase supply or demand.

In the case of agricultural products, weather is an essential factor, as is climate change. Growers need good weather to grow crops. A freeze that kills oranges can drive the price of orange juice up.

Disasters, market influences,  and geopolitical events also affect prices.

If an oil-producing country has a war that destroys its refineries, it will produce less and there may not be enough worldwide supply to meet demand. If drought destroys wheat crops, the supply of wheat will be down.

In contrast, if Arabia decided to increase oil output, that could drive prices down. Plentiful oil means cheaper oil. Sellers are willing to lower their prices to get rid of it.

Metals such as gold and silver often rise in price based on inflation. People buy these metals when inflation goes up. They consider metals a “safe haven” because they maintain value when a currency loses worth because it can’t buy as much.

Also, new technologies can change the value of a commodity. New approaches to producing, harvesting, and shipping commodities can affect the price. Speaking of shipping, slowed shipping limits the supply available and can cause a rise in the price of a commodity, Finally, rumors can cause prices to rise and fall.

Setting target prices

How do you know if prices will go up or down so you can name a price in your contract? This is where you must study. A chart will show you trends in prices, and you can trade according to those trends. You must watch out for a trend reversal. Study charts and get familiar with the signals they give.

Also, get on some social trading platforms and learn from what other traders do.

Managing Risk

You must remain clear that when you buy contracts, you are borrowing money for the purchase. It is called leveraging, and it is done by purchasing options and futures contracts to buy and sell. You may pay as little as 10% of the value of the contract when you buy, but you get the profit on the total amount. However, if prices go against you, you will lose money on the full amount.

You must determine the percentage you are willing to lose. If the trade is losing money, discipline yourself to sell the contract and live to fight another day. Keep your emotions at bay and stick to your selling rules.

Eventually, you may invest in several commodities so that your winners offset losers. This is a strategy for an intermediate to advanced trader who is comfortable enough to buy several contracts at once when investing in commodities.

Alternatives to buying contracts.

If  contracts sound too complex, you can still get commodities exposure by purchasing shares in commodities-based exchange-traded funds ( ETFs), mutual funds, or exchange-traded notes (ETNs).

Look for those that are associated with the commodities you are interested in. These investment vehicles pool investors’ money to buy commodities. You trade them just like you would a stock. Using this method gives you a money manager at the fund who handles all the tricky ins and outs.

You can also simply buy shares in a commodities-based company, such as an oil company or a gold miner. This helps you get started. You can follow share prices the way you would for any stock and understand how you are making (or losing) money. Then later you can move into commodities contracts if you want.

Conclusion

Start small and go slow when investing in commodities. Usually, it is a good idea to put no more than 1-2% of your account balance into any trade, but when investing in commodities, you may start even smaller than that. This is not a get-rich-quick scheme, nor is it gambling. Get a little trading experience by trading money you can afford to lose.

Investors can and do make money by investing in commodities. However, you must educate yourself before jumping in. Even the experts have losing trades.

You may want to consider commodities trading to diversify your investments. Avoid wild guesses and impulse buying, and test your expertise with small trades. They can enhance a portfolio.

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Kevin Johnston

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