Commodities vs Stocks: What Changes When You Trade Commodities?

If you already trade stocks, commodities can look familiar at first. You still have a price, a chart and a view on whether that price may rise or fall. The bigger difference sits underneath the screen.

A stock represents ownership in a business. A commodity derivative is linked to a physical good such as Gold, Crude Oil, Copper or Cotton. That changes what sits behind the price, what can disrupt the market and what a trader needs to think about while holding the position.

When you buy a stock, its value is ultimately connected to the business underneath it. Earnings can grow, margins can improve, debt can fall and management can reinvest capital in ways that make the company more valuable over time.

A commodity does not work that way. A barrel of Crude Oil does not generate earnings while you hold it, and a tonne of Copper does not become more productive because another year has passed.

Its price comes from the market for the physical good itself. How much is being produced? How much is being consumed? How much is already available? How easily can supply respond if demand changes?

For an equity trader, that changes the way you think about what you are analysing. With a stock, you may spend a lot of time asking what the company could earn in the future and what those earnings might be worth. With commodities, the conversation moves much closer to production, consumption and availability.

A stock can change hands repeatedly without being consumed. Commodities move through an actual physical chain.

Crude Oil has to be extracted, transported, stored and refined before it is eventually consumed. Copper has to be mined and processed before it reaches construction, electrical equipment or manufacturing. Cotton has to be grown, harvested, stored and eventually processed by the textile industry.

Once the underlying is physical, inventories, storage and transportation can start to matter.

If the market has more crude oil than it currently needs, the excess still has to go somewhere. If storage tanks have plenty of room, that surplus may be easier to absorb. If storage is already tight, the same additional supply can create a much bigger problem.

A retail trader may never personally deal with an oil tank, warehouse or pipeline, but participants in the physical market do. Producers, processors, manufacturers and other commercial users are constantly dealing with these constraints, and their decisions can eventually show up in the price being traded on the screen.

A stock bought in the cash segment does not have a predetermined expiry date. As long as the company remains listed and you continue to hold the shares, there is no contract date on which the position simply expires.

Commodity futures and options are different because they are contracts with defined expiries.

That means time becomes part of the instrument. You are not simply trading “Gold” or “Crude Oil” in the abstract. You are trading a specific contract linked to that commodity and a particular expiry.

We will get into settlement, delivery and the mechanics of expiry properly in Chapter 7. For now, the important distinction is that a commodity derivative cannot simply be held indefinitely in the way shares purchased in the cash segment can.

Most of the time, storage and expiry sit quietly in the background of a commodity trade. But because the contract is ultimately linked to a physical good, extreme conditions can sometimes produce outcomes that would make very little sense in an equity market. April 2020 gave us one of the clearest examples.

By April 2020, COVID-19 lockdowns had caused oil demand to collapse. Flights were grounded, road travel had fallen sharply and factories across the world were operating below normal levels.

Oil production did not fall at the same speed, so inventories started building and storage became increasingly difficult to secure, particularly at Cushing, Oklahoma, the physical delivery point for West Texas Intermediate, or WTI, crude futures.

At the same time, the May 2020 WTI futures contract was approaching expiry.

Traders who held the contract but had no intention or ability to receive physical oil needed to exit. With storage under severe pressure, there were fewer participants willing to take that obligation.

On 20 April 2020, the May WTI futures contract fell to minus $37.63 per barrel. Traders were effectively willing to pay someone else to take the contract and its delivery obligation off their hands.

Oil did not suddenly become worthless everywhere, nor do commodity prices regularly go negative. What made April 2020 remarkable was that a futures contract linked to a physical commodity could trade below zero because storage, delivery and expiry had all become part of the price.

That kind of outcome has no direct equivalent in the stock market. A stock can collapse towards zero, but holding it does not leave you with a physical asset that has to be stored, transported or delivered.

Because stocks represent businesses, company-specific developments play a major role. Earnings, margins, debt, management decisions and competition can all affect what investors are willing to pay for the company.

Commodity markets connect more directly with the physical economy.

Weather can change crop output. A disruption in a major oil-producing region can affect Crude Oil supply. Industrial activity can change demand for Copper, while currencies and financial conditions can influence Gold.

Stocks can respond to these developments too, so the distinction is not absolute. The difference is that in commodities, an event can sometimes affect the supply or demand for the underlying physical good directly.

A slowdown in manufacturing, for example, may eventually hurt the earnings of a listed company. In Copper, the same slowdown can also change demand for the metal itself.

We will cover these price drivers properly in Chapter 9.

There is another adjustment for someone coming from equities.

A bank and an automobile company may run completely different businesses, but a stock in either still represents ownership in a company.

Gold, Crude Oil, Copper and Turmeric differ at the physical level itself. They are produced differently, stored differently, consumed differently and can face very different supply constraints.

That is why Chapter 3 separated the commodity universe into different families. Knowing that something is a commodity tells you only so much. You also need to know what kind of market sits underneath the contract.

For an equity trader, that is the real shift. The chart may look familiar, but behind it you are now dealing with physical supply, consumption, inventories, storage, expiry and settlement in ways stocks do not normally require you to think about.

That brings us to Chapter 5: Why Trade Commodities?

• Stocks represent ownership in a business, while commodity derivatives are linked to physical goods.
• Commodities can be produced, consumed, transported and stored, so physical constraints can affect their markets.
• Stocks bought in the cash segment do not have a predetermined expiry, while commodity futures and options have defined expiries.
• The April 2020 WTI episode showed how storage pressure, physical delivery and expiry can affect a futures contract.
• Different commodities have different physical market structures, so understanding the market behind the contract matters.