Demystifying the common financial assets: Trading Commodities, Currencies & Cryptocurrencies
When people say they "invest" in Commodities, Currencies or Cryptocurrencies, they are actually trading. What then is the difference you may ask?
More than teaching you about the peculiarities of commodities, currencies and cryptocurrencies (the 3Cs) as financial assets, this post will hopefully provide you clarity to discern between a lot of interchangeable terms and intermingled concepts. Do note that the definitions I use in this post may vary from popular usage, so please allow me this poetic license to help explain to you many concepts that are not as complicated as they may seem.
Commodities.
Broadly speaking, a commodity is any useful or valuable object like shirts, shoes, sand, metals, oil, coal, wheat, cotton etc. Tradable commodities are then those commodities which can be relatively easily bought and sold, or to use our parlance, the liquid commodities.
To be tradable, a commodity has to be fairly standardized, supplied and demanded by a large number of individuals or companies. For example, the shirt in your closet is specific to your size, in a specific design, made of a specific material and your usage overtime has changed its quality. Your used shirt is not standardized when comparing it to a shirt in another person’s closet. You can go and sell your used shirt in a thrift store (if one exists near you) but, we can all agree, it is not relatively easy. The used shirt in your closet, whilst it may be a commodity but it is not, on the relative scale, a tradable commodity.1
Undyed, pure-cotton cloth produced by millers, which can be turned by dyers, designers and tailors into a varied number of clothing items is much more tradable than a blue, cotton shirt. One step earlier, cotton fibers or cotton bales, which can also be mixed with other fibers to produce an even larger variety of goods is a lot more tradable than weaved cotton cloth.
The most tradable of commodities tend to be basic agricultural or mineral goods, which are fairly standardized and are often used as raw materials for subsequent production processes. The most tradable commodities mainly include energy commodities like oil, coal, natural gas; metals like iron, gold, copper; agricultural products like wheat, corn, cotton, coffee; materials such as wood, sand, plastics etc.
Over the past century, the most commonly traded commodities like oil, wheat, natural gas etc have been “financialised” i.e. contracts or financial assets have been created, that would allow the holder of the contract to claim ownership over the physical commodity. For example, I can buy a WTI crude oil futures contract from the New York Mercantile Exchange (NYMEX). With the ownership of this contract I would be able to go to Cushing, Oklahoma on the date specified in the contract and claim physical barrels of crude oil. If I was in the oil refining business, I would transport the crude oil via tankers or pipeline to my oil refinery, process the crude oil into petrol and diesel and sell the petrol and diesel to distributors who then sell it to your local fuel station. Most people buying WTI crude oil futures on the NYMEX or other mercantile exchanges across the world are not actually in the oil refining business. They are traders buying and selling the paper contracts who may have never visited Cushing, Oklahoma or touched crude oil with their bare hands. These traders are trading in a financial asset derived from a physical commodity.
Currencies and Cryptocurrencies…
Money is a medium of exchange, a measure and store of value. In a particular time and area, certain objects called currencies represent money. In the United States, the most recognized form of money today is the US Dollar issued by the US Federal Reserve. Prior to the late 1700s money in the United States used to be represented by a silver metal coin of a standard size. In the United Kingdom today, money is represented in British Pound Sterling or GBP, euros in many European countries, Japanese Yen in Japan and so on.
Cryptocurrencies are special digital objects, exclusively in the digital domain, that are believed by a large number of people to serve as money, hence the term cypto-currency. Whether they truly meet the theoretical definition of money is a debate we won’t go into. The most common cryptocurrencies include Bitcoin, Ethereum, Solana etc, though the space keeps rapidly evolving with each passing day and these may or may not continue to be the most popular cryptocurrencies in the future.
… are just kind of commodities.
Cryptocurrencies are then currencies in the digital domain and currency is a useful, valuable and tradable object recognized by a wide population to serve as money. So at heart both are technically commodities. This helps make the language of the rest of this post a lot simpler allowing us to use the term commodity for all 3Cs.
You don’t invest in commodities.
When you “invest” in something, you expect that thing to generate cash for you. When you invest in setting up a business, you expect to earn profits from that business You expect a higher salary by investing in a university degree, rental income by investing in real estate and a share of all future cash flows by investing in a company’s stock.
When you buy a commodity like oil, the oil itself does not generate any cash flow for you. You can generate additional cash by selling the oil for a price higher than the one you bought it at but now you’re trading.
Trading a commodity involves buying the commodity at the time or place where it is valued low with the expectation of selling it at the time or place where the commodity is valued high.
Confused? Let’s elaborate more on the above statement and see how it works.
Commodities are cheap in areas and time-periods where they are supplied more and demanded less, and expensive in areas and time-periods where they are demanded more and supplied less.
For example, Pakistan produces a lot more rice than what is demanded domestically, so rice in Pakistan is valued lower than Europe where rice is also demanded but there’s not much local production. Thus there’s an opportunity in physical rice trading to buy rice in Pakistan for a lower price of $100 per ton, load it on ships and transport it for a price of $20 per ton and sell it in Europe for $150 per ton, earning a profit of $30 per ton.
Another common pattern is that at harvest time the price of a crop drops since a lot of the harvested crop comes to the market to be sold at the same time. The crop is valued much lower at that point in time relative to the rest of the year. Thus there is an opportunity to buy the crop at harvest time for a low price, store it and sell it at a later time when the excess supply is removed and price of the crops is high. Staying in the same physical location e.g. Pakistan or Chicago in the US, you can buy wheat for $1000 per ton at harvest time, spend $20 per ton to store it in a warehouse for 6 months, and then sell it for a price of $150 per ton, earning a profit of $30 per ton after storage costs. During the course of these 6 months one may say that they have “invested” in wheat but in actuality they’re engaging in temporal trading i.e. trading across time.2
This sounds too easy, so why don’t people use it all the time to get rich?
The above examples were obviously fictional and meant to illustrate an example in a static world. In an efficient free market, these trading opportunities are quickly competed away because of arbitrage. When other people realize that there’s a profit opportunity to buy crops at harvest time, store it and sell it later, they enter the same trade. This results in the price at harvest time going up because of the increased demand by the traders, price of storage going up because now more people want to store wheat in warehouses and prices later in the year not rising as much because more traders would be selling out of their stocks, hence the profit will get competed away. The only difference in crop prices between harvest time and 6-months later will be due to the logistical and financial costs of storing the crop. You can imagine the similar dynamic for physical trading opportunities also being competed away.
Yet we see people trading professionally all the time and consistently getting rich.
While present day markets in the real-world are “largely” free and efficient, there are always frictions, barriers and dislocations present which allows for profitable trading opportunities to pop-up. Spotting and exploiting these trading opportunities requires specialized skills, resources and a risk-taking appetite.
To consistently profit from trading commodities, you either need structural advantages that keeps competition away or access to exclusive information, knowledge or insights which isn’t widely known.
Large companies in the trading business often have structural advantages such as economies of scale, exclusive access to capital or technology, monopoly control over production, exclusive rights to distribution, government licenses etc that prevent competitors from coming in and eroding the profit opportunity. If your company is the only company allowed to export bananas out of a Central American country, then you can make a consistent profit for a long time buying bananas for cheap in that Central America country and selling them in the United States.
If you’re not a large corporation with an entrenched position and are just an individual investor, then information advantages can also unlock persistent profitable trading opportunities for you. Say you have exclusive access to a specialized algorithm that utilizes satellite data to predict South-East Asia’s rice harvest. If you can reliably know before anyone else of whether the region will have a bumper crop or a poor harvest and you can predict its impact on world prices for rice, then you can use this knowledge to trade rice and consistently earn a substantial profit.
If you don’t have an entrenched advantage or access to exclusive knowledge, you can still trade based on “educated guesses” or plain speculation. I’ll use historical examples that come with the obvious benefit of hindsight to illustrate examples of profitable trading opportunities where educated guesses or speculation could have come into play.
Physical Trading: You realize that the size of the South Asian diaspora has surged in the United States in recent years. This diaspora generally has a preference for Basmati amongst all the other varieties of rice, and due to lack of any existing supply of Basmati rice in the US from domestic producers or other traders, most of this demand is unfulfilled. Due to the higher purchasing power of the diaspora in the United States and using other publicly available economic and demographic data, you speculate or rather take an educated guess that Basmati rice can fetch a much higher price in the US as compared to its price in South Asia, hence the opportunity to export Basmati rice out of South Asia to the US.
Temporal Trading: It’s the middle of the coronavirus pandemic, cities and transportation networks are in total lockdown, the price of oil just briefly turned negative for the first time in history and continues to persist far below the average price. Oil has a well-developed futures market where you can buy a contract to buy oil at a future date, say a year later for a price called the future price which reflects the market’s expectations for what the price will be a year later. Say the spot (current) price of Oil is $20 in April 2020 and the future price for April 2021 is $50. You can take a contrarian view and say that you believe that the market is underestimating what the demand for oil will be in April 2021. You say that the market is taking a more pessimistic view of lockdowns largely continuing as present, demand continuing to remain suppressed and the modest increase in price only coming from reduction in supply by oil producers. You are more optimistic on the demand side and take the view that things will recover more than expected over the next 12 months because governments will be forced to reduce lockdown restrictions due to pressure from citizens, wider availability of protective equipment will allow to people to the virus and return to their previous lifestyles and there is a high chance that a vaccine may also be approved by then. Demand for oil will recover more than expected and with supply being cut by oil producers, you speculate that the spot price for oil will actually be around $70 in April 2021. Now in April 2020, you can take the bet of buying an April 2021 future contract for $50 and sell it a year later for $70, earning a handsome 40% return over the year.
What’s the catch, where are the risks?
If you’ve been a regular reader of my posts, you don’t need to be reminded that there are no high returns without high risks. Let’s examine where risk lurks in the physical and temporal commodity trading examples mentioned above.
The government that gave you an exclusive license to export can suddenly take it away. Emerging market countries are highly sensitive to domestic food prices and quickly pull the trigger on banning exports if they see domestic prices rising. In the summer of 2023 the Indian government suddenly announced a ban on exports of rice. If at that time you were an exporter in India holding large stocks of rice, unable to export you may be forced to sell your stocks at a loss in the domestic market with domestic prices around you coming down as a result of the ban on exports.
The exclusive, specialized algorithm that allowed you to reliably forecast South East Asian rice harvest before anyone else gets released into the public domain. Now everyone has access to the information about the upcoming harvests allowing the market to price in this information in advance and eliminating the trading opportunity for you
Your estimates of demand potential may come out wrong. If you venture to pioneer Basmati rice exports to the United States and you put up a large sum of money to buy Basmati Rice in India and load it on ships bound for the US. Upon arriving in the US, you may find that there are no takers for your rice. Since rice is a perishable food item and the cost to transport is high, you may be forced to sell it at a loss to a different market segment like animal feed for salvage value or dispose of it entirely.
Physical trading also carries temporal risks since goods take time to move from one place to another. You may notice today that the price of rice is $100 per ton in Pakistan, $150 in Europe and with a $20 cost to transport you can make a profit by exporting rice from Pakistan to Europe. You will need several weeks to buy the rice in Pakistan, get the necessary quality checks, customs clearance, bank letter of credit and insurance done, load it on ships at a port and then more weeks for the ship to travel from Pakistan to Europe. It is likely that by the time your rice gets to Europe, rice from other exporters who noticed the same opportunity as you gets to Europe first. The price would fall below $150 eroding your profit margin or if it falls below $120 making you a loss.3
When trading across times based on your projections about the future, there’s always the risk that things don’t turn out the way you expected them to. Referring back to the previous example of future oil prices during the coronavirus pandemic, between April 2020 and April 2021, governments may continue to resist pressure to reduce restrictions at the cost of public health risks, a vaccine may not be approved in time, oil producers may stubbornly not cut production and continue keeping the price depressed. As with any speculation, you may be right, you may be more than right, wrong or so wrong as to lose all your money.
Sometimes trading does begin to look like investing
Sometimes due to certain structural reasons, some future projections over a long term can be so reliably that trading begins to look like investing. For an emerging market country like Pakistan with a high inflation rate fueled by the government running a high fiscal deficit, and a large trade deficit of imports outstripping exports, as long as these deficits persist, you can have a high degree of confidence that the Pakistani currency (PKR) will persistently lose value against the US dollar (USD). Many people choose to convert their savings to the US Dollar and maintain USD cash savings. They may say they are choosing to “invest” in the US Dollar but what they’re actually doing is trading the USD-PKR pair of currencies across time. They are selling the PKR today when it has a higher value (to buy USD) to buy it back (by selling USD) in the future when the PKR has a lower value.
Many households in Pakistan do the same trade in gold by keeping gold jewelry or gold coins in their homes or bank lockers. An interesting thing to note is that when you spend PKR to buy gold you are taking on a composite exposure or composite risk. Globally gold prices are most commonly denominated in the US dollar since the US dollar is generally accepted as the world’s reserve currency. So when you spend Pakistani Rupees to buy and hold gold you are exposed to two price movements, that of the PKR against USD and then Gold against USD.
This composite risk also exists when you make foreign investments. As a Pakistani citizen, you may choose to convert the PKR you earned in Pakistan to USD, then use the USD to buy Turkish Lira (TRY) and then use the Turkish Lira to invest in real estate in Istanbul. This is an investment in the sense that you do expect rental cash flows from the real-estate in Istanbul. Since the Turkish tenants will be paying you rent in Turkish Lira, you do also carry the composite exposure of TRY against USD and then PKR against the USD.
I admit that this may be coming across a bit pedantic on what's trading and what’s investing.
If you’re using cash to buy a commodity at a lower price to sell it at a higher price, that’s pure trading. If you’re using cash to buy and start a business with the expectation of holding on to that business for the long-term and earning a return via the profits generated from the business, that’s more towards pure investing. Most financial assets though are a combination of investing and trading.
If you buy a company’s stock only to receive dividend income over time that’s investing. However like the majority of stock investors, you also expect the company’s share price to rise overtime, believing that for some reasons the company’s share have a lower value today and will have higher value in the future, at some threshold of higher value you’ll sell your shares to cash out a profit, then you’re trading. The majority of times when an investor buys a company’s stock or a bond, they are investing and trading at the same time by owning that asset.
To summarize it all in our framework of Risk, Return and Liquidity
Relying on the definitions from earlier in the article, many aspects about commodities, currencies and cryptocurrencies fit neatly in our framework of Risk, Return and Liquidity.
Sort of by definition, the more tradable a particular commodity is, the more liquid it is.
The returns from trading in commodities are entirely capital returns derived from the profits and losses of buying and selling the commodities.
The most important risk then is prices moving contrary to your expectations. With risk, there is upside and more profit when the selling price is much higher than what you anticipated when buying the asset. There is less profit when the price is lower than expected or a loss when the selling price is less than the buying price.
Then there are non-price risk factors. Physical trading of assets carry real-world risks of crime such as theft and arson; accidents such as shipwrecks or extreme weather, infestations or spoilage particularly for agricultural commodities. Financial assets carry the risks of, amongst others, contracts not being honored, counterparties going bankrupt and markets shutting down. For most of these risks, you can buy insurance to reduce the non-price risk factors for a cost that eats into your returns; boiling back down back to our adage of no high return without high risk.
Toyota Corollas are also demanded by large number of people globally, but since they are only produced by one company, new Toyota Corollas are not a tradable commodity. Though used Toyota Corollas in the second-hand market are somewhat closer to being a tradable commodity.
If you expect an asset’s price to go up over time, you can buy that asset today at a low price with the expectation to sell it later at a high price. Here you are taking a “long” trading position on the asset. This is the more intuitive buy and hold approach. If you expect an asset’s price to go down over time, you can also sell the asset today at a high price, to buy it back in the future at a low price. Now you’re taking a “short” position on the asset. The mechanics of taking a short position or short selling is often counter-intuitive for many people, if you’d like me to expand more on how it works, please mention in the comments section of this post.
An exception to this temporal risk exists in the digital realm where things can move in milliseconds. In the nascent days of cryptocurrencies, some traders noticed brief windows of opportunities where the USD price of cryptocurrencies differed between exchanges, allowing for an arbitrage opportunity to rapidly buy from one exchange and sell at the other exchange. Expectedly such opportunities rapidly went away as soon as more traders started noticing it and overtime the market infrastructure improved to remove discrepancies between exchanges.
Insightful, as always.