What are the five rules of trading commodities?
Oil and gold prices are always in the news, along with a list of other commodities that carry a significant influence on the global economy. So how can you start trading commodities, and what are the potential pitfalls? There are no simple answers but the following key principles should serve you well.
1. Focus your energy on a few commodities you understand well
There are approximately two dozen heavily-traded commodities and it is challenging to keep up with all of them. It is good to diversify your commodity portfolio, but this is perhaps best done once you have an in-depth understanding of several commodities to start with. As you learn more about these commodities, your trading knowledge will grow accordingly.
2. Study the impact of macroeconomic events and the interaction of different asset classes
Let’s assume that the Federal Reserve Bank is seeking to raise US interest rates in June 2016. In anticipation of this move, speculators will be buying up dollars and selling foreign currency en masse. This will then drive interest away from equities as higher interest rates are indicative of lower corporate profits in the long run. Investors will therefore seek other safe-haven assets with which to diversify their portfolios – gold, platinum, Treasuries, bonds and fixed-interest savings accounts.
In anticipation of the Fed rate hike, we may see an increase in demand for gold. However as the dollar appreciates, the demand for gold naturally subsides as there is an inverse relationship. Likewise, dollar weakness often precipitates an increase in demand for dollar-denominated commodities such as gold, iron ore and copper. This is because foreign buyers can purchase more of those commodities when the dollar price is lower.
There are many complex relationships like this bearing on the prices of specific commodities. It is your job as a commodities trader to build a deeper understanding of these relationships.
3. Use the news and the experts’ views
These days all world events are reported in real-time and, if you put your ear to the ground, you will hear the rumblings of distant storms. When key market players make announcements about oil, gold, natural gas, iron ore, copper and the like – listen. Timing is everything in commodity trading, and to profit from market movements you need to act swiftly and decisively.
4. Learn when to take profits and how to place Stop Losses
There is no magic wand making it easy for you to learn when to take profits, especially when markets are volatile. As we have seen in oil markets, prices are collapsing through support levels and then bouncing back through resistance levels on an almost daily basis. However, there are other commodities with lower levels of volatility that may offer an equal profit potential.
You should set realistic profit targets based on past performance, current market conditions and support/resistance levels. Stop Losses are an important tool to limit your downside on a trade, although you should remember that a standard stop is not guaranteed and may be subject to slippage or market ‘gapping’.
Another tool that you can use is hedging: this is where you cover your exposure on existing positions with another trade on a related market. One simple example of hedging would be to go long of the VIX (the volatility index) if you’re concerned that your existing positions may be harmed by excessive volatility in the commodity markets.
5. Before you do anything practise on a demo trading account
Too many traders fall into the trap of depositing real money into their online trading accounts with zero experience in commodities trading. It’s akin to getting behind the wheel of a car without having taken a single driving lesson. Always practise with a demo trading account before you deposit money and trade for real: commodities trading is not a game and requires strategy, insight and education. You can help yourself by seeking out trading platforms offering demo trading accounts.
Published: 19 February 2016
You should under no circumstances consider the information and comments provided as an offer or solicitation to invest. This is not investment advice. The information provided is believed to be accurate at the date the information is produced.