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Pros And Cons of Commodity Trading

by janeausten
commodity trading

Advantages of commodity trading

Trading commodities have many benefits and we will talk about some such benefits today: 

Protection against inflation

Since the demand for goods and services increases, it causes a spurt in the rates of these goods and services because commodities which are raw materials for these goods become pricier. Visit multibank group

In an inflationary environment such as the one we mentioned, interest rates increase leading to an increase in borrowing costs which brings down a company’s net income. If the company’s income falls, it implies that its profit would also decline thereby affecting the shareholder’s gains.

This is why during inflation, stock prices keep falling. On the contrary commodity prices needed to manufacture finished products increase due to rising demand, which in turn makes the final product expensive. Therefore, investors shift to commodity futures to keep their capital safe from the effects of inflation and so their investment value stays steady.

Hedge against risky geopolitical events

Geopolitical events like conflicts, riots, and wars could be detrimental to the supply chain which could cause resource scarcity since sourcing and transporting raw materials to factories can become hard. 

In such a scenario, getting a steady supply of raw materials can become a challenge, and hence there is a gap in the demand and supply. This is why prices of commodities increase drastically. When such events take place, the market sentiment is mainly negative because of which the stock prices also crash. This is why investing in commodities could offset losses in an investment portfolio.

High leverage facility

Commodity derivatives such as futures and options allow you to avail an unusually large amount of leverage. You could be in control of a large position and pay not more than 5-10% of the total contract value as an upfront margin.

A negligible move in commodity prices could lead to tremendous profits. This is why you should consider the chances of getting huge returns by trading commodities using leverage. 

The minimum margin for commodity futures could be different but also lower than stocks.

Diversification

Commodities and stocks do not have a positive connection. Commodities are typically raw materials necessary to manufacture finished goods.

Rising commodity prices lead to an increase in production cost which negates profits. It means that shareholders end up with a small amount of earnings per share which eventually causes a fall in stock rates. 

Another thing is that because of inflation, the current value of future cash flows that stocks pay eventually declines as, in the future, the buying capacity of the same amount of cash would reduce. Stock prices decline as a response to this fall in value. Therefore, stocks perform well when the inflation rate is steady or under control while commodities do better when there’s more inflation. 

For example, should there be an increase in the prices of oil, it becomes expensive to own a car and thus car sales are hit which consequently affects auto stock prices. In a similar way, if the prices of metal increase, it becomes pricier to build houses, and thus real estate demand is hit which can be seen in the decline of real estate stocks.

It is because of this negative correlation that if prices of commodities go up, stock prices go down. The losses one has to undergo in stocks can be offset by profits made through commodity derivatives. Therefore, having commodities in your portfolio helps in diversification. 

Commodities react to fundamental factors such as weather, strikes, and geopolitical instability, which could have an impact on supply and demand.

On the other hand, stocks or bonds have different responses to fundamental factors. This is why any movement in commodity prices has little to do with movement in stock prices. It is this negative connection that makes commodities seem like an attractive investment to diversify a portfolio.

Transparency

In comparison to the outcry system in the past, commodity trading now happens online and is accessible to everyone in the market. The electronic trading platform ensures that prices remain fair and there is large-scale participation without any meddling by the buyer and seller. The price determination is steered by forces of demand and supply and thus, manipulation is out of the picture. The price discovery takes place when price and quantity as mentioned by both parties are in sync with one another. 

Disadvantages of trading in commodities

It is wiser to be aware of the drawbacks of trading commodities so you can make an informed decision about using these as an instrument of trade in your journey: 

Leverage

Leverage is a double-edged sword which allows you to be in control of a large amount of capital with minimum investment. It can boost both your profit and loss. Say, the margin required in the beginning is 5%, you’d be able to purchase commodity futures worth $1,00,000 with just that small sum. However, the smallest price change in the contract could affect your profit as well as your loss. 

Volatility

Commodity prices could be highly volatile and are dependent on the market’s forces of demand and supply. Note that the supply and demand of commodities are price inelastic which means, any increase or decrease in prices does not affect the supply of the commodity. 

For instance, it is time-consuming to increase the production of a commodity, extract natural gas from underground or extract iron from deposits of iron ores. Yet, because these are essentials that are part of our everyday lives, price changes would not affect their impact as people may not search for any alternatives. 

Asset concentration

Though diversification could be one of the leading reasons to add commodities to your investment portfolio, the commodity funds are in fact focused on certain industries and are thus, not diverse. This is why any change in commodity prices could affect the share price of a commodity ETF. Know more forex time zone

Despite all its pros and cons, commodity trading continues to be a great way to diversify your investment portfolio and protect against market shocks. It is a great investment option that can be useful for wealth creation. 

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