How to trade CFDs on commodities

How to trade CFDs on commodities

Here, we’re going to go through how you can trade CFDs on commodities. CFDs can be an effective way to trade commodities, so it’s worth you understanding them.

Firstly, a little background knowledge on both.

What are commodities?

Commodities are, simply, everyday goods. Wheat is a commodity. So is the gas you use to heat your home, and the copper that forms a part of your fibre-optic broadband cable.

Because commodities are prone to the same price swings as any asset, they can be traded.

The most commonly traded commodities include:

• Crude oil
• Brent oil
• Natural gas
• Soybeans
• Corn
• Gold
• Copper
• Silver

But theoretically, almost any commodity can be traded if traders believe they can make money from it.

What are the potential upsides of trading commodities?

• Commodities can be an effective hedge during bear markets. Commodities and commodity stocks often perform differently to company shares in certain market environments. That means that if stocks are falling, commodities may rise, helping you to offset some risk. (Though obviously this is a simplified explanation, and diversification is a complicated topic!)
• When commodities rise in price, they can really rise. When commodities go through a bull run, they can perform exceptionally well, and often hit all-time highs. This unique environment is known as a commodity ‘supercycle’. ‘Supercycles’ are relatively rare, but can be lucrative for traders who know how to take advantage of them.
• Commodities can be an effective anti-inflation strategy. Inflation tends to erode returns in stocks and bonds, but commodities often out-perform during inflationary periods. This isn’t really surprising; inflation is, after all, the increase in price of everyday goods – which is what commodities are!

What are the potential downsides of trading commodities?

• Commodities can be volatile. Just as commodities will often hit all-time highs during their bear markets, they can also swing down in price quite quickly, in ‘boom and bust’ cycles. If you don’t like to deal with too much volatility, trading commodities may not be for you.
• Commodities are susceptible to outside events. There are a lot of factors that can influence commodity performance, from geo-politics to domestic regulation. In just the last couple of years alone, we’ve seen commodity prices hit massive highs and lows as a result of first Brexit, and then the invasion of the Ukraine.
• Commodities can stay flat for long periods of time. Unlike stocks, which (usually) trend broadly upwards over time, commodities are perfectly capable of staying flat over long-term periods, especially between their ‘supercycles’.

Now, let’s go into commodity CFDs…

There are 3 main benefits of using CFDs:

1. CFDs mean you don’t actually have to own the commodities to trade them. You are simply speculating on the price.

2. You can go long or short, using the same execution process. You don’t have to worry about having to borrow the goods or incur extra fees as you would if you were traditionally short-selling.

3. CFDs allow you to access larger trades with less capital, through leverage. (There are risks involved in this, which we’ll cover in more depth in a moment.)

What are CFDs?

CFD stands for ‘Contract for Difference’.

When you open a CFD, you agree with the broker to exchange the difference between an asset’s price when you open the trade and an asset’s price when you close the trade.

So, if you open a contract on gold when the price is at $2,000, and the price rises to $2,200, and you close the contract, the difference is $200. This would be your profit (assuming you went long on the trade).

The size of your total trade depends on how many contracts you issue at once. The price of each contract is determined by the price of a ‘lot’ of that asset.

Each individual asset has a unique lot.

• For stocks, the ‘lot’ is the price of one share
• For crude oil, the ‘lot’ is the price of 100 barrels
• For gold and silver, the ‘lot’ is the price of 100 troy ounces

And so on. So, every contract you open is priced the same as 1 lot.

Now, that sounds complicated, but it’s fairly easy to understand once you’ve got your head around it.

Let’s go through a step-by-step example of how a commodity CFD trade would work:

1. You decide to place a CFD trade on Gold. (One of the most traded commodities.)

2. The current value of a ‘lot’ of Gold is, as we said, the price of 100 troy ounces.

3. At the time you open the trade, that price is $1,988.

4. You decide to open 5 contracts, so your total trade size is $9,940. ($1,988 x 5.)

5. Over the next 3 hours, the price of a ‘lot’ (or one contract) rises to be worth $2,100. This is an increase of $112.

6. You close the trade, with a profit of $112 for each contract. You opened five contracts, so your total profit is $560.

Though the price move we’ve used in this example would be considered quite big, this is a clear example of how CFDs work on any trade. (Not just commodities.)

Leverage

More often than not, CFD traders use leverage, so it’s important you understand how leverage works.

Essentially, leverage means you borrow money from the CFD broker so you can place larger trades, without needing to supply all the money upfront.

So, let’s go back to our gold example trade.

Let’s say that rather than placing 5 contracts, you wanted to place 25.

This would mean a total trade size of $49,700. ($1,988 x 25.)

This is quite a sizeable trade.

But, if you use leverage, you can place that trade without needing to actually supply the full $49,700 upfront.

How much leverage you can use will depend on your broker, but for the purposes of this example, let’s say you use leverage of 1:40.

To work out how much capital you’ll need to supply upfront, you divide the total size of the trade ($49,700) by the second, larger number in the leverage figure (which is 40 here).

So, your capital will be $49,700 divided by 40.

In this case, then, you’ll need to supply $1,242.50 in capital upfront to place this trade. (Plus your margin.)

The risks of leverage (calculating profits and losses)

The key point you need to understand about using leverage with CFDs is that when you use leverage, your profits and losses are calculated based on the size of the trade, not on how much actual money you’ve put into it.

So, in this case, your profits and losses would be calculated on the $49,700 figure, not on the $1,242.50.

Let’s assume that you make the same profit we mentioned earlier, of $112 on each contract.

If you placed 25 contracts, this would give you a total profit of $2,800. ($112 x 25.)

Because you only actually traded with $1,242.50 of your real capital, this means that you’ve more than doubled your money on the trade in a relatively short space of time.

As you can imagine, this potential is one of the key reasons why leverage is popular with traders.

However, it’s important for you to understand that the same principle applies to losses.

So, had you lost $112 on each contract, and your total loss had been $2,800, you would have lost more than double the money you initially put in.

That is why leverage is considered a very high-risk strategy.

Unlike traditional stock trades, where the most you can lose is the capital you put in, when you use leverage, you can lose more. And the higher your leverage, the more these losses can be magnified.

That’s why, as with all trades, you should never trade with money you can’t afford to lose.

Summing up

Commodities can play a key part in any trader’s portfolio, if you’re prepared to deal with the potential volatility and the potential for external events to impact your trades.

CFDs can be an effective way to buy and sell commodities, if you don’t want to own the underlying asset, and you plan to go both long and short, while using leverage.

As always, make sure you thoroughly understand the risks before placing any trade, and never trade with money you can’t afford to lose.