Aside from stocks and foreign currencies, another asset that has its own exchange market is commodities. A commodity is a raw material or a primary product that could be bought and sold. Commodity trading has many similarities to stock trading, but it involves the buying of selling of primary products instead of stocks. In this article, we are going to have a brief overview of what commodity trading is and its pros and cons for investors.
What is commodity trading?
Commodities are traded through a commodity market. A commodity market is an exchange where trades in the primary economic sector take place. Commodity trading usually involves the use of derivatives or futures contract. These contracts are traded following the real value of a commodity. These are often used by farmers or those who make a living out of commodities to hedge against the possibility of their produce to lose value.
High potential returns – Historically speaking, the growth value of commodities has risen significantly over time. There had been instances that certain commodities raised even more than three times their original price. The fast rising in price is an effect of the supply and demand for the primary products in the economy.
Diversification – Investors of stocks and bonds who want to diversify their portfolio benefit greatly from commodities. This is because commodities have their own market that is separate from the other exchanges, which makes it valuable to those who are afraid of a sudden collapse.
Read more about the introduction to portfolio diversification.
Defense against inflation – Based on studies, commodities have the tendency to correlate with inflation. This gives it an advantage to rise in value during periods of rising inflation.
Value assurance – Since the price of the futures contract is derived from the price of the commodity, there is an assurance that its value would never fall to zero. These contracts are valued with the real assets that have their own prices in the economy, which typically stay steady during periods of inflation and economic weakness.
Demand – Commodity trading is also influenced by the growth in demand for the commodity itself. Consumer demand plays a big role whether the prices go up and down.
Risk – As much as commodities could rise in value, there is also a chance that they could lose just as much. The commodity market usually goes through long and extended movements, so they can easily reverse to the opposite way of the trend without any forewarning. Thus, it makes it more difficult to predict the possible trend of the market.
High volatility – Commodities are considered as one of the most volatile type of security. Based on research, it was found out that commodities are twice as volatile as stocks and four times as bonds. This makes it riskier for investors and especially speculators to predict.
Read more about how to conquer volatile markets.
No steady income – Unlike the other types of financial assets, commodities have no way to generate steady income for investors. Profits are only realized at the end of the contract itself.
Looking at the pros and cons of commodity trading, it is a very risky business. But considering the number of advantages you can benefit from it generally overcomes all the risk that is involved. As always, careful study and analysis helps to secure the potential returns.
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