Commodities are an asset class and provide a different type of trading experience relative to stocks and bonds. Bonds and stocks both generally provide a combination of a fixed return and capital appreciation, commodities are an asset class that only provide capital appreciation. Most traders focus on the directional commodity traders, but trading calendar spreads and inter-commodity spread are also a strategy that is popular.
Directional trading of commodities is probably the most popular style of trading. This type of trading is best geared toward products that have robust liquidity. Liquidity is the ability to enter and exit a trade with little slippage. You can determine the liquidity of a product by analyzing the bid/offer spread. The tighter the spread, the better the liquidity. Assets such as crude oil, heating oil, gasoline, gold, silver, copper, soybeans and corn are all very liquid commodities.
Commodities provide access to speculating on both up and downward movements in the asset class. Most commodities are traded around the clock, with liquidity being the highest during the European and North American trading hours.
Supply and Demand
The fundamental of most commodities are based on the supply and demand balance. For example, crude oil fundamentals are generally based on the change in inventories. Every week, in the United States, the Department of Energy releases a report that reflects the inventory level of crude oil, along with inventory levels of heating oil and gasoline. In addition, the DOE releases data on demand for these products in the United States. Since the United States is the world’s largest consumer of oil products, it is important to follow this release. The Department of Energy also releases data every week on natural gas, providing traders of this product a view of inventories levels as well as implied demand.
Another type of trading in the world of commodities is spread trading. Spread trading or market neutral trading is based on the concept that you are long one asset and simultaneously short another asset. The concept is similar to a currency pair where you might be long the dollar and short the euro. Inter spread trading is very popular in the commodity arena.
One of the most active types of trades is trading the energy cracks. The crack is the difference between products, such as heating oil and gasoline, relative to crude oil. The crack is the refining margin, and it represents what a refiner makes when it turns crude oil into a product like gasoline. Crack trading is very active and it allows an investor to assume a relative value trade, that is based on the difference between two commodity products as opposed to directional risk.
In closing, trading commodities involves understanding the fundamentals as well as finding assets that provide enough liquidity to enter and exit with little slippage. Additionally, many commodities are traded as relative value trades, which can reflect an actual business that appears in real world situation.