Liquidity is one of the most important factors in the commodity market, where commodities are traded continuously and in large quantities. Liquidity means the ability to buy and sell assets easily without affecting the market price. Typically, liquid assets are safer than illiquid assets, as it is easy to enter and exit positions.
What are commodities?
Raw materials are traded in several ways. First, there is the physical commodity market. For example, a barrel of oil, a bar of gold, a truckload of corn or soybeans, a bag of coffee, or even a herd of cattle are examples of physical commodities that constitute the essence of commodity markets.
Everything that is traded is a derivative. This is an instrument that is influenced by the value of the underlying asset of the hard commodity. Trading in physical commodities occurs between producers, traders, and end consumers. In derivative markets, assets are traded by speculators, investors, price controllers, and other interested parties.
What is liquidity in commodities?
Different raw materials provide different degrees of liquidity. Let’s take a look at some of the most liquid and least liquid commodity sectors and specific markets to understand the concept of liquidity.
Precious metals: The most liquid precious metal is gold, as it is traded more than any other precious metal. Gold is traded in the physical market and in futures and options markets, as well as in exchange-traded funds (ETFs) and exchange-traded notes (ETNs) based on the metal. Other precious metals are less liquid. For example, there is more trading in gold than in the other precious metal, rhodium, as there are no futures contracts for rhodium.
Energy: Crude oil may be the most traded and widespread commodity in the world. While coal is not traded to the same extent or with the same number of derivatives that are traded in the case of crude oil. Thus, crude oil is considered a more liquid energy commodity than coal.
These are just two cases of commodities in the same sector enjoying different degrees of liquidity. All major sectors contain commodities with different degrees of liquidity, including other metals, energy, grains, soft commodities, and animal proteins or meats.
How can you tell if a commodity market is liquid?
There are certain conditions that make the market liquid. Look for these characteristics that are typically found in all liquid commodity markets:
- An active or primary cash market for the physical commodities
- A large number of buyers and sellers – hedgers, speculators, investors, and others
- An open, transparent, and non-discriminatory delivery method
- A defined relationship between the derivative and the physical commodity
- A means to exchange the cash and derivative commodity
- A convergence between the cash commodity price and future delivery prices over time
Futures markets are considered the most liquid as they meet all these characteristics. You can measure the liquidity of specific futures product by monitoring daily trading volume, open interest, and number of open long and short positions (not closed). The higher the trading volume and open interest, the more liquid the market.
Why is liquidity important?
Liquidity is important for all assets, not just commodities. Liquidity ensures that traders can buy and sell easily, bringing speculators and investors into the market. Illiquid markets tend to be more volatile than liquid markets because fewer transactions can make pricing less stable. In fact, the most important feature of liquidity is that it reduces the cost of trading or investing.
When investing in commodities – or any other asset class – be sure to choose liquid instruments so you can buy and sell without hassle at the lowest trading cost. The spread between supply and demand for assets represents the cost of buying and selling. More liquid assets tend to have the narrowest spread between buy and sell prices. Illiquid markets tend to have wider spreads between buy and sell prices, increasing trading costs.
Source:
https://www.thebalancemoney.com/liquidity-in-commodities-808992
Leave a Reply