With exceptionally wet weather and widespread flooding in the UK’s agricultural heartland early this winter, the value of trading in commodities has never been clearer. Already farmers, often knee-deep in mud on their usually arable land, are warning of difficulties in sowing crops and also that prices for wheat and the like will rise, with knock-on effects for other commodities such as livestock.

It is the way of the world that such terrible news often presents an opportunity for those with the eye and know-how to turn a profit. Contracts for Difference (CFDs) are one way to achieve this.

‘Commodity prices are very susceptible to news flow, and wheat, and its supply, is among those,’ comments Michael Hewson, senior market analyst at CMC Markets. He says intelligent traders will use news, be it about environmental, demographic, economic or political events, to supplement their technical and fundamental analysis.

CFDs are an agreement between two parties to exchange the difference between the opening and closing prices of a contract, in this case relating to commodities. They allow you to take a leveraged position on live price moves without actually owning the commodity. The idea is you speculate on whether prices will rise, which is known in the industry as going ‘long’, or fall, which is known as going ‘short’.

If your view proves correct, you book a profit in relation to the price differential. If it is wrong, you swallow a loss. Do not forget that CFDs are leveraged so the financial risk exposure may be greater than your initial outlay.

‘It is massively important to understand that your losses can be magnified in exactly the same way as your profits,’ reminds Josh Raymond of City Index, who explains that a losing investment can be compared to going into negative equity in the housing market. ‘Traders need to both acknowledge that,
and make themselves aware of risk management techniques.’

Companies such as CMC Markets, IG, GFT UK, City Index, TD Direct Investing and FP Markets facilitate CFDs trades on commodities via desktops and laptops, tablets and smartphones.

All that glitters

Commodities are goods that are interchangeable with other produce of exactly the same type. For example, wheat from the UK would be comparable with same the product from the US. There is no difference between UK and Australian livestock. Thus, commodity trading is about the way in which goods are bought and sold around the world, and that means understanding the principles of demand and supply is essential.

To return to the UK example, National Farmers’ Union figures show the wet weather saw UK wheat production fall by 14.6%. This and drought elsewhere in the world, such as in the USA, means the overall supply of grain is down and demand and prices are up. This has sent livestock farmers’ feed bills higher, and with them the prices of meat.

Traders who kept a close eye on their sectors of choice - in this case wheat, livestock and meat - and stayed abreast of key news would have quickly spied the potential for a lucrative CFD and taken a risk-assessed position with a view to profiting on the supply/demand imbalance.

‘As with all commodities, supply and demand issues remain crucial when trading CFDs, since sentiment can swing wildly following unexpected changes in stockpiles,’ explains Chris Beauchamp of IG, as he highlights the value of technical research to analyse pricing patterns.

‘Time frames are all important, since a shorter-term trader will take more notice of regular supply and demand data than someone who is looking at a long-term trend,’ he says, pointing to the value of being able to identify key trading data such as price resistance and support.

Taking CFDs on the future price of commodities such as precious metals like gold, silver or palladium, energy assets such as oil, heating oil and gasoline or agricultural products like soybeans, corn and wheat is not the same as trading futures.

CFDs are a type of derivative, while futures are a product that is traded. Placing CFDs on equities or equities indices that are dominated by commodity companies is not the same as placing a CFD on commodities themselves.

‘Since CFDs are leveraged products, the trader does not need large sums of money to speculate on markets that are otherwise unavailable to many retail customers,’ reminds Fawad Razaqzada of GFT Global Markets.

How it works

Assume, for example, Chicago Wheat (March contract) is trading at $7.525 to $7.515 per bushel. A Chicago Wheat contract provides exposure to 5,000 bushels. You speculate that Chicago Wheat will rise in the short term, and therefore buy five contracts of the same.

Your opening position equates to $188,125, or $7.525 x 5 x 5,000. Your margin deposit is, say, $1,500, to reflect the leveraged nature of the position.

The price of Chicago Wheat then rises to $7.855 to $7.845, and you decide to take a profit. Your closing position equates to $196,125, or $7.845 x 5 x 5,000.

Thus, your gross profit is $8,000, or $196,125 less $188,125. After allowing for your margin deposit, your net profit would be $6,500. If Chicago Wheat fell by a similar amount, you would lose $8,000.

Research-based trading

The key to successful commodities trading with CFDs lies in meticulous and robust research, followed by more research, and then the objective translation of this into measured trading positions.

‘This allows you to carefully work out your entry and exit points in a commodity trade,’ says Raymond.

Every CFD position should have its own methodology, and how individual traders arrive at the point of taking that position is an often interesting route.

The basic rule of supply and demand again enters the equation. Oversupply results in lower prices, while undersupply leads to higher ones. As one would reasonably expect, supply and demand fluctuate in relation to one another over time, and depending on the commodity being traded that could be anything from a matter of seconds up to a question of months and years.

All of this means CFD commodity speculators can have a tough time divining future prices and pricing trends, and the entry and exit points for trades.

‘My advice to novice traders is to understand the market and understand it well. Knowing how price action works, for example old support levels becoming new resistance and vice versa, can put you miles ahead, and hopefully help you make decent profit,’ counsels Razaqzada.

Commodity punters could also use technical analysis, which assumes fundamental study is factored into a commodity’s price very quickly and therefore involves minute examination and extrapolation of a commodity’s historic pricing action, often dating back years.

‘Using a variety of indicators, technical analysis will allow you to time entry and exit times for your CFD by looking at historical congestion points, such as previous highs and lows,’ explains CMC’s Hewson. ‘Technical analysis will tell you whether a commodity price is trending, or trading in a price range, and tools such as oscillators can tell you whether a specific asset or market is overbought or oversold.’

Most CFD houses offer a comprehensive range of real-time analytical tools to traders, and these can include detailed data breakdowns on trade within in a particular commodity, notably volumes, last trade and normal market size, in addition to news flow, and chart analysis.

CMC Markets, IG and City Index are just some of the leading CFD providers to offer analytical tools for those with an eye to mastering the pricing curve. Displays such as candlesticks, lines and bars can be summoned to deepen your understanding of key trends, while software programs can help identify patterns and even let you add your own lines of price analysis and extrapolation.

CFD traders who use these tools should be looking to spot emerging pricing trends, estimate the longevity of existing ones, identify key pivot points in market prices, and look for pricing support and resistance levels. All of this research feeds into rationale behind a CFD trade.

Managing risk

As already noted, leveraged market speculation with CFDs means commodity traders can potentially earn or lose more than their initial outlay in taking a position. The best CFD traders are acutely aware of this, and manage their risk exposure carefully.

The most important point is to understand that margin, also referred to as your deposit, is a reference to the leverage you are taking on. If your margin is 5%, your leverage is 95%.

You want to be mindful of cumulative leverage, which occurs when you have too many CFD positions open at any given time. If they all go well, you are quids in, but if they all go wrong, you will definitely feel the acute financial pinch.

‘It is generally up to the individual to monitor their margin and trades,’ warns Beauchamp of IG. He notes how responsible CFD providers often alert clients when they have run out of margin.

Inexperienced traders are advised to use common sense, and be wary of greed. Most CFD traders use stop losses to protect themselves from unexpected price moves. These mechanisms automatically trigger a trade that closes your CFD position when a certain price is reached, whether on the long side or the short side, to prevent the accumulation of uncomfortable, or even unaffordable, losses.

Profit and loss management is also a part of the risk management armoury. Successful CFD traders often have pre-set price points at which they will either enter or leave a position.

The less successful, often misled by greed or hope, are more casual in their method and want to milk every last penny of profit, or pray the market will turn to their favour.

‘Clients need to keep the rules of risk management close by at all times, namely using stops and carefully controlling position sizes,’ Beauchamp affirms.

Hewson adds: ‘People who are new to CFDs should be wary of complacency when holding an open position, and they should not confuse short-term trading with long-term investing.’