Technical vs. fundamental analysis for commodity markets – What’s the difference?
Analysis has played a major role in attempting to decipher how the commodity markets (price) will move with hopes of giving a user the upperhand on how and when to enter the market.
For anyone who has followed the commodity futures market whether it is a farmer, a market speculator, or a purchaser of a commodity, they have heard of and most likely used some form of market analysis. Although there are many forms of analysis, this Michigan State University Extension article will focus on two main types of analysis: fundamental analysis and technical analysis.
Commodity traders and others have used numerous (and sometimes humorous) techniques to determine when to buy and sell a futures commodity contract, everything from the phases of the moon and mathematical equations to what amounts to wives tales and gut feelings. Many will utilize either a technical analysis approach, take a fundamental analysis approach or a combination there of. These two methods have been described, as one is the way the world works, the other is a way of trying to guess it.
Fundamental analysis looks at the world around us to help determine what direction the markets may take. An example would be that if there is a freeze predicted for the Florida region that grows oranges at a time of year that the freeze could destroy the buds on the trees significantly lowering the orange yield for the year. One could predict that if the freeze takes place and there is a significant reduction in oranges (using supply and demand theory) and the demand for the oranges does not change then the price of oranges and frozen orange juice would increase following the freeze. A trader upon hearing the news of the possible deep freeze may purchase a contract of frozen orange juice before the freeze. If the freeze does take place and there is a significant loss then the contract of frozen orange juice may have gone up in price allowing the purchaser to sell his contract at a profit. Besides weather, geopolitics and economics play an important role in the value of a commodity; import/export market changes, currency exchange rates, wars, changes in social and cultural norms, disease and even the time of the year all can play a role in price fluctuation of a commodity futures contract.
The biggest challenge with using only a fundamental analysis approach is that the market has usually already built in the geopolitical variables into a commodity’s price before a farmer or other users/producers of commodities can react. Thus the information that can be gathered through fundamental analysis has its best use in the mid to long-term outlook of the market. This develops a difficult situation if one were to use solely fundamental analysis to look for market turning points, making technical analysis useful as a price risk management tool.
Technical analysis utilizes current and historical data to develop a perspective on how the markets may react. Many individuals will be most familiar with some of the common technical analysis use of graphical charts. Once a chart or other data is developed and analyzed for patterns. Based on historical knowledge, many believe that when certain patterns can be found, one can determine with a higher rate of accuracy of how the market will react. In theory this gives a person a potential advantage to enter the market where they feel they have the most to gain. Unfortunately, just because a pattern exists and in the past the market has reacted in a certain way, it does not mean that the same market reaction will take place again.
There are a number of rules of thumbs on how the markets react under certain circumstances but there is always a second rule of thumb that remains the same –don’t follow the first rule of thumb because it is not a guarantee. As a Michigan State University Extension educator, I advise people to look for those historic patterns that act as an indicator on what might happen while understanding that there are multiple variables at play that may move the market in a complete opposite direction than expected.
In most cases, individuals who utilize the commodity futures market will utilize a bit of both types of analysis to help them determine the best time and price to enter the market. Individuals who either need to make delivery or take delivery of a commodity may also use a simple time, date and/or price mechanism throughout the year using a theory of averages.
For further information you can read commodity market technical analysis lecture notes. For further farm management information please feel free to go to the MSU Extension farm management webpage for additional information or to look up your local regional farm management educator.