Investing and trading require one to have a sound financial understanding and the ability to look at the bigger picture. 

There are several ways that you can take to diversify your investment portfolio and maximize the gains. Commodities are one such option you can choose to leverage the benefit of economic cycles.

Initially, it may look like commodities is the same as equity. And yes, the basic functioning of both equity and commodities remains the same, and SEBI is the market regulator.

But you need to understand that there is a much higher risk associated with commodity rather than equity. This article goes over the top six risks of commodity trading.

1. Volatility


The commodities market is one where people leverage the momentary price fluctuations and use that to make money. The volatility of the market depends on the commodity in question.

For example, raw commodities such as steel display lower volatility as compared to that of precious metals like gold or silver.

If it's really hard for a trader to manage the volatility, and they take up more trade than they can afford, it can cause catastrophic results.

To avoid such a situation, you need to plan your commodities trade only after understanding the past charts of the commodity.

While taking a trade, ensure that you have your eyes on the market so that you can act on any sudden changes and thereby minimize your loss.

2. Leverage


First off, you need to realize is that in commodities trading, you will be posting only 5 -15% of the contract's value. Such a meager payment will control the overall terms of the contract.

Imagine a situation wherein the current price of crude oil stands at $72 a barrel. Assuming that crude oil futures contracts happen in lots of 1000 barrels, the value of this contract will be $72,000.

Now, as a trader, you will only be about $10,000 to control the $72,000 worth of crude oil.

On the positive side, every time the price of crude oil moves by $1, you will earn $1000. This is a significant amount for the monetary investment involved.

The price of crude oil can move by $3 (or more) either in the positive or the negative direction. This is about a 30% move on the margin that was initially paid to establish the contract.

Thus, you see that while you stand to make significant profits in commodity trading, the same can backfire and cause you to lose significant money.

3. Market Contributors


The commodities trading market is extremely volatile, and political and economic factors are a major contributor.

The possibility of war or tensions between your country and a neighboring one often have a bearish impact on commodities' future.

It may not be possible to predict such occurrences time and again. But keeping a close eye on the indexes of prime exchanges such as SHFE, COMEX, NYMEX, BSE, and LME will help you make better decisions.

You can consider using tools like Tradingview to get a one-stop account of the charts and indexes that you will need before venturing into commodities trading.

4. Emotional Influence


Ideally, all of one’s trading decisions should be based on market analysis. However, because of the high stakes involved, commodity traders often run the risk of letting their emotions dictate their trading decisions.

A classic example of this is when a trader is in a loss - not letting go of the contract because they are in denial of the bad decision.

Such emotional influence not only leads to bigger losses but may also cause one to raise their stakes unnecessarily to cover up the loss.

The chances of losing more money increases, and one is then stuck in a deadly game of cat and mouse.

To avoid this risk, it is important to have a sense of personal discipline and aim for profits only when you can afford the losses as well.

5. Unforeseen Risks


Some factors beyond your control often play an instrumental role in deciding the outcome of your commodity trade. These include unexpected rainfall, floods, earthquakes, terrorist attack, etc.

For example, the occurrence of bird flu takes a toll on the demand for poultry products. As a result, their prices fall. If you invested in the poultry commodity, you would be running into losses for no fault of yours.

6. Inexperience


The most common mistakes in commodity trading stem from inexperience, wherein a person does not know the basics of commodity trading.

Since such people have made a haphazard jump into the world of commodities, they often end up investing too much in the wrong places and wipe off all their capital within the first 5 trades.

To avoid this risk, spend time studying about the commodity market and the commodity you intend to invest in.

Read up on the factors that influence it, its past trends, and then figure out good entry points. Ideally, you should do paper-trading for a few days before you get down to the real commodity trading.

Moreover, it is useful to decide on the amount of money that you can invest in commodities. Make sure that irrespective of profits or losses, you stay true to the pre-decided amount.

Closing Thoughts


Being aware of these risks helps you evaluate whether the trade you have in mind is worth the risk.

Since it takes place in the future, you must take a calculative approach to commodities trading. To invest in commodities on a short-term basis, consider using Quant trading for a better chance at doubling your profits.

Ideally, you should be able to decide your commodity's chart patterns and use that to take a call on the investment.

For medium to long tenure commodity investments, you need to adopt a combination of fundamental and technical analysis. That way, short term price swings will not affect you.

Eventually, it is your risk appetite, the amount of effort you are ready to put in, and the desire to make big profits that will determine if you should include commodities in your portfolio.