There are several ways to trade in the markets today. But a vast majority of people still prefer stocks and bonds when it comes to trading and investing. However, you can use any or a combination of two or more financial products to trade and invest thereby diversifying your portfolio. One of the options is commodities trading. Although it was once mainly limited to the large institutional traders, today it is rather easy to trade commodities.
CFDs (contracts-for-difference) are a common way to trade on commodities on the market. Recently, several traders have shown interest in commodities trading due to which the market has witnessed a surge of interest in CFDs. Traders earn profits from the price movement of commodities on the market.
- Commodities are hard assets you can touch.
- They are classified into several groups such as agricultural, energy, and metals.
- Their prices are traded every day in the commodities market, and this result in price variation for the end-user.
What are commodities?
That brings us to the basic question – what are commodities? In simple terms, a commodity is any basic good that is interchangeable with other goods of the same type and used in commerce. It can be any hard asset such as wheat, gold, or oil. Commodities are commonly used as raw materials in the production of other goods or services.
Commodities are traded on commodity exchanges and brokerage firms. Some of the commonly traded commodity CFDs are:
- Precious metals – this includes valuable metals such as gold, silver, copper, platinum, and palladium
- Energy – this includes natural gas, intermediate crude oil, Brent crude oil, propane, and heating oil
- Agriculture – products such as coffee, cotton, wheat, oats, sugar, lumber, cocoa, soybeans, and orange juice
- Livestock – animals such as cattle, feeder cattle, hogs, and pork include in this category
- Industrial metals – this category includes metals used in industrial applications such as aluminium, nickel, tin, lead, molybdenum, recycled steel, and zinc, among others
Who trades commodities?
Both individual traders and large businesses trade commodities every day. Some traders trade them for the sole purpose of earning a profit, while others trade them for business needs. For instance, a chocolate manufacturer would need to purchase cocoa for its chocolates. The company would enter a commodity contract for the cocoa to be delivered at its premises on a future date. When it buys the cocoa before it is needed, the company is locking the price. Conversely, the cocoa farmers use the commodity market to sell their cocoa to be delivered on a future date to the company for the agreed price.
Commodities are traded on various exchanges. However, most people use brokerage firms for commodity trading. Commodities trading is a good approach to diversify your portfolio. Although it might sound a bit apprehensive, commodity trading is simpler than you think. Apart from direct commodity trading, you can also trade in commodity derivatives.
Futures traders sell their contracts before the expiry date. Sooner or later, a trader that needs the commodity will buy the product and take possession — like the chocolate maker that needs cocoa for its chocolates.
How to trade commodities?
It is possible to trade commodities using any of the instruments mentioned below:
- CFDs (contracts for difference) – here profit or loss results from the difference in price at the time the contract is made and when it is executed. If the price is higher when the product is delivered, the trader makes money. Conversely, if it is lower, he loses money.
- ETFs (exchange-traded funds) – these are like mutual funds for one or more commodities.
- Stocks – they provide ownership in companies producing or extracting commodities such as gold or crude oil.
- Futures – they allow the trader to buy a commodity at a future date at a price agreed upon at the time of entering the contract.
- Options – they give traders the right (but not obligation) to purchase a commodity at a future date. As the traders pay a premium for the contract, they might lose money if the commodity price increases.
Commodities trading with CFDs
CFDs are contracts between two parties based on the price differences between the time of entering the contract and the price when the contract ends. If the ending trade price is greater than the opening price, the CFDs will earn you profit in the form of a difference in these prices. In such a scenario, the seller of the contract will pay the buyer the difference. On the other hand, if the closing trade price is lower than the entry price, the seller of the contract will earn profit as he sold or shorted the commodity. In this case, the buyer pays the seller the difference.
It is important to remember that when you trade CFDs, you are not buying the commodity. You are just speculating on the price variations and making your decisions accordingly.
Trading precious metal and commodities using CFDs
As mentioned above, CFD is a contract between two parties - you and another. Before getting into a CFD, you must decide the commodity you want to trade along with the direction of the price. Several traders use technical analysis and track current and future price directions with the help of charts.
So, if you decide to trade in gold, and think that the price of gold will increase on a future date, you will buy a gold CFD. By doing so, you are going long. If you paid $1000 for a gold CFD and after a month you will close your CFD as the price of gold moved up. Your profit would be the difference between what you paid and what you got for it when you sold it. If you sold the contract at $1750, you would profit $750 less the commission cost.
However, if your analysis tells you that the gold prices are going to fall, you could sell your CFD. In such a case, you will be going short. In the example above, you would sell (go short) a gold CDF for $1000. If the price of gold fell to $800 when you closed out your position, you would profit by $200.
Reducing the risks
Like any other trade, commodity trade can also result in loss. For instance, in the above examples, if the prices had moved in the other direction than you expected, you would have had to sell your CFD for a loss. So, learning to trade CFD also requires learning about the risks involved and how to mitigate them. One of the ways to manage risk is hedging. It is a risk management technique that can be used to reduce losses. You can hedge to protect your profit, particularly during uncertain market conditions. The idea behind hedging is that if one investment goes against you, your hedge position will work in your favour.
Find a Broker
Before you can trade CFDs, you will need to find a broker and get approval for trading in a margin account. It must be noted that some brokerage firms don’t allow clients from every country. So look around for brokerages that accept clients from your country and choose one that suits your situation.
Many brokers provide demo accounts you can use to try out CFD trading before you enter the market. It is a great way to learn the trade without risking your money. If you are new to trading, you should use the demo account and familiarise yourself with everything.
Pros and cons of CFDs
There are several advantages and disadvantages of trading CFDs over other forms of commodity trading.
Advantages of CFD Trading
- As CFDs don’t have an expiry date, the exact timing of price movements need not be a concern.
- It is possible to profit from both rising and fall in commodity prices.
- As you can borrow by trading on margin, you don’t need the full amount of money to trade CFDs.
Disadvantages of CFD Trading
- Although seemingly simple, CFDs are derivatives that require expert knowledge and research.
- You don’t own the actual asset you trade.
- Trading on margin can also end up costing you more than you are risking.
Trading commodities using CFDs is a good way to earn profits in the commodities market, regardless of price rise or fall. However, entering commodity trading via CFDs should not be taken lightly as you can end up losing money if you don’t play your cards right. It is always better to get ample practice on how to trade CFD contracts, by using the demo account before risking actual money. Hedging can help you mitigate the risk once you start trading.
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