Why Is Liquidity So Important in Commodities

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Commodities can be more volatile than other forms of investment, so liquidity is of prime concern. Buying or selling an asset easily without hurting the market price makes for a liquid asset. Liquidity tends to occur when an asset has a high level of trading. Investing in liquid assets is often safer than illiquid ones, because it's easy to get in and out of positions.

Key Takeaways

  • In the world of investing, commodities are raw materials such as oil, gold, corn, soybeans, coffee, cattle, and more.
  • Commodities tend to be more volatile than other investments. Before making a trade, keep in mind liquidity. That's the ability to buy and sell your assets.
  • Each commodity category—such as precious metals, energy, or grains—includes some commodities that are more liquid, while others are less liquid.
  • When buying commodities or any asset, be sure to choose ones that are liquid.

What Are Commodities?

Raw materials trade in a number of ways. First there's the physical commodity market. 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 the physical staples at the heart of commodity markets.

Everything else that trades is a derivative. This is an instrument with a price that reflects the value of the underlying hard commodity asset. Physical commodity trading occurs among producers, traders, and the end consumers. In the derivative markets, it's the speculators, investors, arbitrageurs, and other interested parties who make the assets liquid.

Think of commodity markets as a pyramid. At the top are the assets themselves. Below that are derivatives. The next level is the over-the-counter (OTC) market. Forwards and swaps are principal-to-principal, often financially settled instruments. However, they can and do often allow for physical delivery of the commodity asset. The next step on the pyramid are the futures and options contracts that trade on exchanges. These contracts allow a wide and diverse group of market players to have an interest, or "position," in the price movements of commodities. The next level of the pyramid consists of ETF and ETN products designed to mimic price variations in the assets they purport to represent.

What Is Liquidity in Commodities?

Different commodity raw materials offer different degrees of liquidity. Let's look at some of the more liquid and less liquid commodity sectors and specific markets to understand the concept of liquidity.

  • Precious metals: The most liquid precious metal is gold, because it has more trading activity than any other precious metal. Gold trades in the physical market as well as in the OTC forward and swap markets. There are liquid gold futures and options contracts on exchanges as well as ETF and ETN products based on the metal. Other precious metals are less liquid. For instance, there's rhodium, another precious metal. Rhodium only trades in the physical market. That makes gold far more liquid than rhodium because there are no rhodium futures to trade.
  • Energy: Crude oil may be the most liquidly traded and prevalent commodity in the world. Coal, meanwhile, does not trade to the same extent or with as many derivatives as crude oil does. Therefore, crude oil is a more liquid energy commodity than coal.

Those are just two cases of commodities within the same sector having different degrees of liquidity. All of the major sectors have them—including other metals, energies, grains, soft commodities, and animal proteins or meats.

How Can You Tell Whether a Commodity Market Is Liquid?

Certain conditions make a market liquid. Look for these characteristics, which tend to be the case in all liquid commodity markets:

  • An active spot or cash underlying market in the physical commodity
  • Many buyers and sellers—hedgers, speculators, investors, and others
  • An open, transparent, and non-discriminatory delivery method
  • A well-defined relationship between the derivative and the physical commodity
  • A way to exchange the cash commodity and derivative
  • A convergence of the cash price and prices that reflect future delivery over time

Futures markets are more liquid because they meet all these characteristics. You can measure the liquidity of specific futures products by looking at daily trading volumes and open interest, and the number of open (but not closed) long and short positions. The higher the volume and open interest, the more liquid a market is.

Why Is Liquidity Important?

Liquidity is important for all assets, not just commodities. Liquidity ensures traders can buy and sell easily. That brings speculators and investors into a market. An illiquid market tends to be far more volatile than a liquid one because fewer trades can make pricing less stable. Indeed, the most important feature of liquidity is that it lowers the cost to trade or invest.

When investing in commodities—or any asset class—make sure you choose liquid instruments so that you can buy and sell without problems at the lowest trading cost. The bid/offer spread on an asset represents the cost to buy and sell. The most liquid assets have the tightest bid/offer spreads. Less liquid markets tend to have a wider spread between buying and selling prices, thus raising trading costs.

Article Sources

  1. Trading Economics. "Rhodium."

  2. World Gold Council. "The Global Gold Market."

  3. Trading Economics. "Crude Oil."

  4. American Coal Council. "Coal Trading FAQs."