When a trader hears the term ‘commodities’, he is quite likely to think of the futures market where commodities have been traded for many decades. In fact, the commodity markets are arguably one of the oldest forms of trading in the world. Thousands of years ago, men were already trading basic commodities markets like wheat and gold in markets around the world, from ancient Egypt to China. Commodities include agricultural products such as corn and wheat, energy products such as oil and gas, and base and precious metals, including gold and silver.
Who trades the commodity markets though? In traditional commodity markets, this was the producers – those companies that were putting commodities for sale into the market – and their consumers. A common example of a producer today would be a mining company like Rio Tinto that mines base metals out of the ground, and a consumer might take the form of a ship building company, which needs to ensure a constant supply of metal at an acceptable price. Alongside these are the speculators and day traders, looking to trade the commodities with the ultimate goal of trying to extract a profit from changes in commodity prices.
It is well known that the futures markets have long been associated with speculation and risk, even though they can equally well be used as a hedging mechanism and are used by manufacturers to guarantee the price of their raw materials. The problem with futures was that you had to be able to afford to buy at least one commodities futures contract on a big exchange in order to get exposure to a particular commodities market, but this could cost thousands of dollars. The alternative was to buy shares directly into the company that produced the resource like buying shares in Rio Tinto for instance but then you are exposed to the fundamentals and general management of the company. The commodities markets have today become much more affordable for private investors. In recent years contracts for difference have also become available on commodities, so now the trader has an alternative and in many ways superior financial vehicle for speculation.
CFD brokers quote prices on many of the more popular global commodity markets which include metals, like gold and silver, energy markets like oil and natural gas, base metals like copper, and agricultural commodities like cocoa, lumber or wheat…etc Although there are some CFDs based on the spot or market pricing, many of the commodity CFDs have the futures market as the underlying value. This means that there is an expiration date associated with each contract which differ from other CFDs since the expiry date is based on the settlement date of the associated futures contract.
CFD brokers deal with this in one of two ways. Either the broker will arrange for an automatic rollover to the next monthly contract when the underlying futures contract expires, or he may provide a cash settlement to end the contract with an offer to manually take up the next month’s contract.
There are several advantages to trading commodities using CFDs, compared to using futures contracts. Depending on the commodity, with a futures contract there is the possibility or risk that you will have to take delivery of the underlying. With CFDs, you do own actual the gold or oil or other commodity, you are simply trading the price of these commodities and you will always get a cash settlement – you will never run the risk of a truckload of lean hogs being delivered to your doorsteps.
With CFDs you also have the inherent advantage of trading commodities on margin: which means that you only have to deposit a small percentage of the overall value of the trade with the CFD broker, but taking on the whole profit or loss instead. You will likely find that the margin required for trading CFDs rather than futures is much lower percentage, which means you will pay less for a position in the same amount of commodities. However, the main reason you will pay less when trading commodity CFDs is that you do not have to take the standard size traded on the futures market, which can be substantial for a small trader. In fact most commodity CFDs mirror the futures markets but trade in smaller units which makes it easier to manage risk. The minimum lot sizes vary depending on your broker, but the margins required to be deposited to open a position will invariably be less than that required by the underlying futures contract. For instance, US Crude Oil may be quoted at a lot size of 25 barrels, compared with a typical futures contract size of 1,000. Also, oil is quoted on a 24-hour basis and while some speculators utilise ETFs to deal in commodities these are not available round-the-clock – so if you need to wait until the NYSE ARCA market opens you might miss out on opportunities.
The other major advantage of trading commodities with CFDs unlike, say, buying a share in BP, which will only do well if the price of oil goes up, with a contract for difference you can also profit if the price goes down by placing a ‘short’ or ‘sell’ trade. As with futures, you will be charged interest on a daily basis to your account when you take a long position, and the interest rate is likely to be similar. If you take a short position, you will receive daily interest, although this will be at a lower rate than you would pay when holding the long CFD. Few brokers charge commission on commodity CFDs, instead they make their profit from the spread between the bid and ask prices, that is the selling and buying prices.
Note that different commodities have a different measurement scale, and consequently are priced differently. Each commodity is priced per unit – the cost to buy a barrel of oil, or a troy ounce of gold, or, say, a bushel of wheat for instance. When trading CFDs it is crucial that you have access to some historical charts so that you get an idea of the kind of daily movements that can occur in the commodity you are interested to trade – if starting out with a limited balance you need to stay away from markets which are highly volatile like lumber or strictly limit your trade size to a minimum.
An example trade in soybeans might go like this. The quoted price is $909.75 bid and $912.50 ask. With soybeans, these values are per 100. To buy a contract and go long you would pay the ask price, and the standard size is 200 bushels. This means the value is $912.50 x 2, which is $1,825.00, and the margin cost may be $90. The standard lot size for a futures contract is 5,000 bushels, costing significantly more.
If the soybeans go up in value by $10 (per 100), then your profit would be $20. That means a 1% rise in the price just returned more than 20% on your trade. The leveraging power of CFDs multiplies your profit.
The majority of the more liquid commodity markets are open almost on a 24-hour basis during which time they witness a mixture of open outcry and electronic trading. Take the COMEX Gold futures contracts for instance. These are pit-traded from 1.20pm to 6.30pm (UK time) but will still be available to trade on electronic platforms round-the-clock taking away a 45-minute break at 10.15pm. The CFD hours will normally follow those trading times. Oil futures contracts are also practically quoted on a 24-hour basis, although some of the more ‘exotic’ commodities will only be available for a few hours during the day.
Note that sometimes you will see commodity contracts quoted with a monthly date next to them (say September 2010). This denotes the month on which the referenced contract that the CFD is based on will expire on. Commodities futures exchanges list contracts that entitle the holder to take delivery of the actual physical commodity asset (which includes live cows, ingots of metal…etc!) when the contract expires – at the expiry price. This is great if you need to produce something, but not that good if you are a speculator and simply want to profit from price changes. Fortunately, as a CFD trader, you are one step away from this problem: the CFD will track price changes of the underlying future contract without the danger of your having to look for a warehouse to take delivery of 50 tons of corn?
One thing to be careful of with commodity futures trading is how futures contracts rollover into new contracts on expiry date as this could impact your overall profit or loss. Normally, the future price of a commodity is higher than the present spot price, with the gap in-between the two prices getting smaller as the future contract reaches expiry date. This is referred to as ‘contango’ and an investor would incur a loss when they roll a position to the subsequent future contract. There is another phenomenon commonly known as ‘backwardation’ which is the exact opposite and happens when futures prices diverse from the spot prices as the expiry date of the contract draws near. Backwardation can happen if there is a shortage of the commodity and here an investor would stand to make a gain everytime they roll to the next contract. Contango and backwardation phenomenons affect all trading products including futures, exchange traded funds and CFD trading products and the prices of future CFDs can thus differ from the spot prices by a couple of dollars depending on when the next contract expiry is.
It is interesting to note that some of the more popular commodity contracts include Oil CFDs and Gold CFDs. Oil is often regarded as a benchmark of the health of the global economy: speculators believe that when the economy is doing well, more oil will be consumed, and the price will consequently rise. Gold on the other hand is considered a measure of confidence (or the lack of it) in the global economy and paper currencies.