Pros and Cons of Commodity Trading

Advantages of Commodity Trading

There are several advantages and disadvantages of commodity trading in India. Let us first take a look at the list of advantages of commodity trading:

• Protects Against Inflation

Inflation is the slow and steady rise in the prices of goods and services. Such an increase is prompted whenever the demand for products and services exceeds supply, persuading manufacturers to use more raw materials and raising costs. 

In this regard, investing in commodities may provide a wise means of keeping pace with rising prices since the price of commodities appreciates in inflationary scenarios. This approach allows the investor to handle issues posed by increasing costs in the economy. 

• Offers High-leverage Facilities

Many derivatives in commodities, whether futures or options, provide the investor with a great deal of scope through leverage to make trades. Essentially, leverage augmentation will enjoy funds that have been borrowed for funding any asset purchases, and as such, traders have to deposit a minimum limit known as margin. 

In general, an investor must pay a margin of between 5% and 10% of the contract value. As a result, larger commodity market positions can be manipulated with reasonable initial investments. 

• Hedge Against Geopolitical Tensions

Geopolitical events like riots, wars and political instability can greatly affect a country's supply chain, leading to scarcity. Transportation problems also serve to worsen the situation and create obstacles for manufacturers to get raw materials.

Fortunately, investing in commodities can offset losses in the investors' portfolios during difficult times for those willing to act. When investors trade in commodities, they exploit price movements to attract benefits while shielding their investments from the unfavourable effects of geopolitical tensions. 

• Diversification 

Typically, commodities have low or negative correlations with stock and bond returns. When commodity prices rise, it raises production costs, squeezing manufacturers' margins and reducing shareholders' earnings. These conditions tend to weigh on stock prices. 

However, in inflationary times, commodities generally outperform. Commodities can offset losses in traditional assets through diversification. For example, a rise in fuel prices can hurt automobile stocks, but trading petrol or diesel commodities can hedge against those losses profitably. 

Disadvantages of Commodity Trading

Besides understanding its meaning, it is just as important to explore the various risks and benefits of commodity trading. Given below are a few disadvantages:

• High Volatility

Commodity prices are highly volatile, primarily driven by supply and demand and external factors such as geopolitical events, natural disasters and political instability. These events can quickly alter market prices, making it challenging for investors to analyse trends and manage risks effectively. 

Moreover, finance experts note that commodities are among the most volatile asset classes, often being twice as volatile as stocks and four times more so than bonds. Hence, such volatility makes commodity trading risky for many investors.

• Speculation

While commodity trading is highly speculative, it attracts investors willing to take risks for short time frames in search of quick returns. This influx leads to bumper bull-trade swings that change rapidly in the commodities market. 

Hence, this conscious buying and selling activity creates volatility on the commodities' trading floors. It results in uncertain price predictions through predictive modelling by other investors. 

• Asset Concentration 

Commodity funds are an easy way for the investor to diversify their portfolios. However, they often focus on one or two industries at most, which defeats the purpose of diversification. Thus, the inclusion of commodities trading in an investor's portfolio may defeat the point of spreading broader diversification across various asset classes.

It may also lead to increased exposure to sector-specific risks and compromised effectiveness of the entire investment strategy. 

Things to Consider Before Investing in Commodities 

After understanding the pros and cons of commodity trading, here are a few things you must consider before trading in the commodity market:

• Trading Volume

The trading volume of commodities has a significant bearing on any decision-making related to investment. High trading volume implies activity in buying and selling, suggesting liquidity and probably a price rise. Increased volume creates an environment for day trading, where traders can benefit from price fluctuations and accumulate substantial profits.

• Risk Profile Analysis

Establish your risk profile before investing in commodities. Looking at the various levels at which different commodities stack up and understanding your risk appetite will help you make an informed decision. Higher risks may give higher returns, but higher losses may tend to creep in, making it a careful consideration.

• Picking Commodities with Good Demand

Investing in widely traded commodities tends to lend more exposure. These include agriculture, energy, base metals and precious metals. Commodities such as crude oil, gold and natural gas usually attract investor attention due to their liquidity and historical performance, thus providing an attractive channel for generating returns.

• Dumping the Uncertain Commodities

You must exercise caution in commodities that have unpredictable price swings. While brief bullish manoeuvres might easily offer avenues for making a profit, the risks are still very high. Understanding market dynamics and historical performance is paramount to avoiding investing in commodities that may collapse after a rise in the short run. 

Disclaimer: This content is solely for educational purposes. The securities/investments quoted here are not recommendatory.