Commodity vs Forex Trading - Understand the Difference | Angel One (2024)

The fundamental difference between forex and commodity trading has to do with the underlying security. Commodities trade involves goods like cocoa, coffee, and products that can be mined like oil and gold. On the other hand, forex —or foreign exchange — is a global market that trades in currencies like rupees, euros, dollars, and yen. There are certain similarities between commodities vs forex trading with respect to their approaches and analysis. However, there are a variety of factors that can help you choose which market is ideal for you.

Unlike stocks that are driven by fundamentals, both commodities and forex markets are dictated by macro-economic factors that cause demand and supply, trade and geopolitics. Moreover, commodities and currency are global markets, which lend investors insight into international affairs.

Commodity Trading

As of today, there are around 50 well-known commodity markets globally. These markets facilitate investment trading in around 100 different primary commodities.The commodities traded in the market can roughly be placed in four categories – energy, agricultural produce, metals and bullion. Natural gas, crude oil, gasoline and heating oil are included in energy. The prices of these products are influenced by economic developments and supply of oil from the biggest wells around the world. Investors should track developments in OPEC, alternative energy, and economic pitfalls.

Sugar, cotton, coffee, cocoa, soybeans, black pepper, castor seeds and cardamom are among agricultural produce in which traders invest. Bullion refers to precious metals such as gold, silver and platinum. Other metals such as copper, lead, zinc and nickel are also traded on the commodities market.

There are many ways to invest within a commodity but the most direct way is to buy into a futures contract. This is a contract where a holder is obligated to sell or buy a certain commodity at a specified price on a future delivery date. There are three crucial players that make commodity trading.

Commercials or Hedgers: These are the entities that are involved in the processing, duction, or merchandising of a commodity. For example, corn farmers serve as commercials for the commodity of corn. Commercials account for the majority of commodity trading.

Large Speculators: These involve a group of investors who have pooled their money thereby reducing their risk and increasing their gain. Similar to mutual funds, these large speculators have money managers who help make their investment decisions.

Small Speculators: Small speculators are the individual commodity traders who trade via a commodity broker or through their own accounts. Both major and small speculators have the ability to heavily affect the commodities market.

Commodity Trading Advantages

The advantages of trading in commodities are that

1. Commodities make great diversifying options for a portfolio.
2. Investors get exposure to global markets.
3. Commodities have longer market hours which allow for more trading time.
4. Most commodities have seasonal patterns that can be tracked.
5. Commodities can be traded with somewhat higher leverage than some securities.
6. Commodities have a lower transaction cost than other securities.
7. Commodities can make for effective carry trades.

Commodity Trading Disadvantages

1. Even though commodities ensure portfolio diversification, the fact that they tend to belong to a few concentrated industries limits the overall diversification of assets.
2. Commodity prices are highly volatile, which presents the risk of major shifts in prices.
3. According to past trends, during higher volatility, commodities led to smaller long-term returns when compared to stocks. Higher leverage creates higher risk for speculators.

Currency Trading

When it comes to forex markets, they mainly comprise commercial companies, banks, investment management firms, retail forex brokers, and hedge funds. Forex is currently the biggest financial market in the world. Currency rates on forex are a factor of the demand and supply of the country’s currency by investors on the market. This demand and supply depend upon inflation, interest rates, economic uncertainty, trade balance, political scenarios, and more within a certain country. In general, the level of confidence in a country’s economy influences the currency’s price on forex.

Foreign exchange or forex is the exchange of international currencies in pairs. In India, stock exchanges such as the National Stock Exchange (NSE), Bombay Stock Exchange (BSE), United Stock Exchange (USE) and MCX-SX provide the marketplace for the sale and purchase of currencies. Worldwide, forex is the largest market, although only a small number of currency pairs drive the volume of trading.

Commercial banks, central banks, corporates, forex brokers, investment management firms, hedge funds and retail investors participate in currency trading. For trading in this market, investors need not open a Demat account. Only a trading account with a broker will suffice since cash or equity, used by the stock market, are not used in currency trading. The forex market operates only between 9:00 am and 5:00 pm, and investors can trade only in the futures and options segments.

How currency trading works

Pairs

Unlike other markets where a single security, stock or commodity is traded, in currency markets trading takes place in pairs. This means that you have to buy one currency and sell the other for each transaction. These pairs are expressed as (currency 1/currency 2), where currency 1 is the base currency and currency 1 is the quote currency.

In India, currency trading is allowed in these pairs: (USD/INR), (EUR/INR), (JPY/INR), (GBP/INR), (EUR/USD), (GBP/USD) and (USD/JPY). The major pairs, which almost always involve the US dollar, are (USD/EUR), (USD/CAD) and (USD/GBP). Pairs that do not involve the US dollar are called minor pairs. Exotic pairs are those where one currency is major and the other is minor.

Pips

Pip stands for percentage in point, or price interest point and is the smallest change in the valuation of a currency pair. It is one-hundredth of one percent, or the fourth decimal place. It is used to determine gains or losses upon the trading of a currency pair.

Future derivatives

Forex trade in India takes place through currency derivatives such as futures contracts, forex spots and forwards. Futures contracts mention the date, quantity and price at which currencies will be traded in the future. This method is used in the forex market instead of physically exchanging the currencies to trade.

Currency Trading Advantages

1. Currency trading is highly liquid so you can easily access your returns in case of any financial emergency.
2. Similar to commodities, investors get exposure to global markets by trading currencies.
3. Currency markets are open all day for five days of the week which makes for flexible trading hours.
4. Currencies offer higher leverage than commodity trading.
5. Investing in currencies can be used as a diversification tool.
6. You can hedge your forex investments to protect it from any political or event-based risk.

Currency Trading Disadvantages

1. Forex markets, dependent on elections and geopolitical tensions, are highly volatile and difficult to predict. Small adverse changes in pip can result in massive losses.
2. Seeking high leverages can also lead to losses based on the risk involved and management of your finances.
3. The global currency market is poorly regulated. Dominated by brokers and banks, it can give way to price manipulations and scams.

Commodity vs Forex Trading

Trading on forex vs commodities markets is similar on certain fronts and different on others. Similar to commodity trading, you can use currency futures on forex to speculate the short term movement of the markets. Another similarity is that you have the benefit of arbitrage with both commodity and forex trading. This implies you can earn returns by taking advantage of the varying exchange rates of the same currency or commodity in different markets.

However, when it comes to regulation in forex vs commodities markets, commodities are heavily regulated while forex trading is more loosely regulated. Finally, forex is traded over the counter through brokers or banks while commodities trade on an exchange. Hence, commodities have daily limits which if exceeded, prohibit further trading. However, for investors seeking diversification and exposure to global markets, both make for effective investments.