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Here is why commodities are here to stay in our portfolio

From mainstays such as oil and gold to newcomers such as palladium, commodities derivatives offer diverse paths for traders to achieve their financial goals.

Here is why commodities are here to stay in our portfolio

Many investors use commodities as a hedge against inflation, since rising commodity prices are a characteristic of inflation. Photos: Shutterstock

It has been an exciting year for commodities markets, with the prices of oil and coal surging to multi-year highs amid energy shortages in China, the world’s second-largest economy. Looking ahead, analysts expect prices to stay at elevated levels into 2022.

Commodities like oil and coal are part of a broad asset class that can provide investors with an alternative path to generating returns beyond traditional stocks or bonds. Commodities are classified into two broad categories – namely, hard and soft commodities. Hard commodities refer to those that are extracted or mined, such as precious metals. Soft commodities  are those that are grown or farmed, such as coffee, livestock or rice.

Many investors use commodities as a hedge against inflation, since rising commodity prices are a characteristic of inflation, which erodes the purchasing power of currencies and returns from other investments. For instance, companies such as airlines can purchase commodities derivatives to lock in future fuel contracts to hedge against possible oil price increases.

As commodity prices tend to be more volatile compared to other asset classes, they present short-term traders with plenty of opportunities to profit. To capitalise on the price movements of commodities, traders can make use of derivatives products like Contract for Difference (CFDs) that allow them to go long or short. One can trade CFDs in popular commodities such as oil and gold, or agricultural products such as coffee and wheat, as well as metals.

OIL AND GOLD: PERENNIAL FAVOURITES

BStudio Oil Shutterstock

Ask anyone to name two globally traded commodity markets, and most people are likely to say oil and gold. The emergence of financial products such as CFDs that offer trading in these assets without a huge financial commitment has made them more accessible to retail traders.

Traditionally, traders and investors have used gold as a hedge against inflation, a weakening economy and a falling stock market.

However, the effectiveness of gold as a hedge can change depending on market conditions. During the COVID-19 pandemic, for example, gold began moving in tandem with stocks, so it’s important for traders to monitor gold analyst coverage to identify market trends.

Oil is another commodity that regularly attracts the attention of mainstream news. As oil is key to the global economy, traders need to keep up with geopolitical developments that can affect prices and volatility.

According to an ebook on commodities written in collaboration with IG and Bloomberg, oil markets have historically been driven by trends and momentum: “When a sharp uptrend or downtrend is established by the institutional traders who dominate the market, the resulting dramatic price movement generates headlines, which draws in a flood of smaller players, which accelerates the trend to sometimes extreme levels.”

BASE METALS: THE CLEANEST ECONOMIC INDICATORS

BStudio Palladium Shutterstock

Base metals such as copper and iron ore are two of the other commonly traded commodities.

As base metals are used regularly by businesses around the world, they are often regarded as the “cleanest” indicators of global economic health. As such, these assets are far less prone to confusing price behaviour compared to gold, while remaining volatile enough to present trading opportunities.

Base metal prices are affected by not just physical supply and demand factors, but also perceptions of demand and supply. An external factor could be a labour strike at a mine, for instance, which presents traders an opportunity to anticipate the market’s reaction to this event.

Another metal – palladium – has been the standout base metal commodity performer for the last half a decade, booming from less than US$700 (S$948) an ounce in 2017 to a peak of almost US$3,000 in April 2021, according to Bloomberg data. The metal is a critical component in catalytic converters, which transform toxic gases produced by vehicles into safer emissions.

Stricter emissions regulations and the growing popularity of hybrid vehicles are driving demand for palladium, a metal rarer than gold.

SOFT COMMODITIES: SEASONALITY MATTERS

BStudio Soy Shtterstock

Soft commodities encompass any resource that can be grown, reared and harvested for use in food, biofuel or manufacturing. There are tradeable contracts in everything from coffee and sugar to soybeans.

With the exception of coffee, most “softs markets” are less liquid than their hard counterparts, but they can still reward retail traders who are prepared to study them.

Like the other commodities, softs prices are subjected to general driving forces – weather, seasonality, the US dollar – but they also have their own characteristics. It is particularly important to understand seasonality factors for softs like cocoa and soybeans that are dependent on a small number of major growers. Meanwhile, coffee prices have spiked this year amid shortages and disruptions to supply chains.

TRADING COMMODITIES THROUGH CFDS

As is evident in many asset classes today, volatility is a common condition in the financial markets. A great way to capitalise on these market swings is through the use of CFDs. Volatility offers CFD traders the opportunity to benefit from these price swings by going either long or short on the same assets.

In this way, traders are able to make a profit from either direction of the market, as they are able to take a long position if they expect the commodity’s price to go up, or a short position if they expect the price to fall.

For instance, traders could have taken advantage of the recent pullback in commodities such as iron ore by going short on a CFD for the metal. This way, traders can make a profit when the market moves in their chosen direction. Since you are able to take short positions, CFDs can also act as a hedge for your portfolio.

Commodity contracts usually involve large volumes and high costs; one standard crude oil contract at US$70 per barrel is US$70,000. However, trading CFDs only requires you to deposit a fraction of the full value of trade. This deposit is known as a margin. Being able to trade on a margin means that you tie up less of your capital.

This leverage can amplify returns from winning trades but can also inflate losses very rapidly, so traders need to employ risk management strategies such as stops, guaranteed stops and limits to reduce the chance of heavy losses.

For those keen on exploring opportunities in commodities, CFD provider IG offers over 35 commodities CFDs and a range of CFDs on commodity stocks and exchange-traded funds (ETFs). Its risk management product – Knock-Outs – comes with an in-built guaranteed stop, while allowing traders to determine the amount of risk they are willing to take at the start of the trade. Traders will know beforehand the maximum loss that they could potentially incur, which is especially useful for new traders when trading in volatile markets.

For traders looking to expand their opportunities for profit, accessing the universe of commodities through CFDs is one path that they can pursue.

To get a better understanding of commodities trading, watch this IG video and download IG’s free Bloomberg e-book, Commodities: Strike when it's hot.

IG provides an execution-only service. The information in this article is for informational and educational purposes only and does not constitute (and should not be construed as containing) any form of financial or investment advice or an investment recommendation or an offer of or solicitation to invest or transact in any financial instrument. Nor does the information take into account the investment objective, financial situation or particular need of any person. Where in doubt, you should seek advice from an independent financial adviser regarding the suitability of your investment, under a separate arrangement, as you deem fit.

No responsibility is accepted by IG for any loss or damage arising in any way (including due to negligence) from anyone acting or refraining from acting as a result of the information. All forms of investment carry risks. Trading in leveraged products such as CFDs carries risks and may not be suitable for everyone. Losses can exceed deposits.

This advertisement has not been reviewed by the Monetary Authority of Singapore.

 

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