What is CFD in the Commodity Market?

Commodity Contracts for Difference (CFD) are derivative instruments that allow traders to speculate on future price movements of commodities in the market. Originally, the commodity market only involved producers, consumers, and other financial institutions such as investment banks.

As a retail trader with lower capital, you can use CFDs to participate in the commodity market and speculate on price movements without actually owning the underlying asset—in this case, the commodities themselves.

Before we explore how you can trade commodity CFDs, let's delve into some essential concepts.

Commodity Classification

Commodities fall into two main categories: soft commodities and hard commodities.

Soft commodities are products of agriculture or livestock. In this case, items such as coffee, wheat, and cotton are considered soft commodities.

Hard commodities are minerals that are mined or extracted from the earth. Great examples of hard commodities include oil, gold, and copper.

However, trading platforms might categorize commodities differently, such as using the following four sub-categories:

• Energy – These markets involve natural energy resources, including crude oil, natural gas, and heating oil.

• Metals – The metals sub-category relates to precious metals that are mined, such as copper, platinum, gold, and silver.

• Agriculture – This sub-category includes all products grown for food, clothing, or building materials. These include cocoa, sugar, and lumber.

• Livestock and Meat – This sub-category is for animals raised for meat and other products such as gelatin and leather. You'll find all animal products here.

Factors Influencing Commodity Prices

Several factors drive the prices of commodities in the market. Let's consider a few:

• Supply and Demand – The market forces of supply and demand determine commodity prices. The general rule here is: an increase in demand for a commodity will cause its price to rise. If there is a shortage in inventory or a decrease in supply, that too will cause a price increase. Conversely, a decrease in demand will cause commodity prices to fall.

• Political and Geopolitical Situations – A change in national, regional, or global policies can affect commodity prices. For instance, commodity prices may decrease if your country reduces import taxes. Conflicts and wars can also impact commodity prices. Wars disrupt production processes, affect currency, and cut off supply routes, leading to shortages.

• Competition – Alternative energy sources, for example, compete with crude oil and natural gas. As there is a global shift towards renewable energy sources, governments and companies are gradually moving away from oil and natural gas.

• Macroeconomics – If your country's economy is weak, the demand for commodities will decrease, leading to lower prices. Booming economies cause commodity prices to surge, especially in the construction and transportation sectors.

• Currency Fluctuations – Most commodities are priced in USD. Whenever the US dollar's value fluctuates, so does the cost of commodities. For instance, if the USD strengthens against a basket of other major currencies, buying commodities priced in dollars becomes cheaper.

How Commodity CFDs Work

Commodity CFDs are similar to CFDs in other asset classes. They share features such as leveraged margin and have similar trading fees. Trading commodity CFDs also carries the double-edged sword of profit and loss. While you have the potential to profit in both rising and falling markets by using CFDs, there is also a higher risk of capital loss.

Let's examine the features of commodity CFDs.

Leverage in Commodity CFDs

Commodity CFDs use leverage. Leverage increases your exposure to the commodity market without having to pay upfront for the total cost of the asset.

Leverage in commodity CFD trades holds significant potential for both profits and losses. Your profit and loss depend on the full size of your position, not just your investment capital. Without a proper risk management strategy, you could lose more than your initial capital.

Margin in Commodity CFD Trading

Margin is the minimum capital that your account requires to open a CFD position. In most cases, your broker will require your account to have two types of margin:

• Deposit Margin

• Maintenance Margin

Deposit margin is what you need to start. You need your deposit margin to open a leveraged commodity CFD position.

On the other hand, maintenance margin keeps your commodity CFD positions open. Suppose an open trade in your account moves into a loss. Your deposit and other available funds in your account may cover that trade. If these funds are insufficient, your trading platform will use your maintenance margin to keep those positions open.

Without maintenance margin, your broker will force you out of your positions. You will also receive a margin call, which is a request to fund your trading account with more money.

Fees in Commodity CFD Trading

Commodity trading using CFDs incurs costs similar to other CFD trading. They include:

• Spread: The spread is the difference between the buying and selling price of a commodity. Every commodity CFD trade you make incurs a spread. Lower spreads are better because any small movement in your prediction's favor means higher profits.

• Commission: Depending on your broker or jurisdiction, you may need to pay a commission when you trade some CFDs.

• Market Data Fees: If you want access to data that can help you make better trades, you may pay market data fees for up-to-date information on all commodities.

• Maintenance Fees: To keep a position open overnight, you may have to pay your broker a holding fee. These fees vary depending on whether your open trade is profitable.

How to Trade Commodities

You can start trading commodity CFDs today with the following quick steps:

1. Open and fund your online CFD trading account.

2. Develop a trading strategy.

3. Choose your Commodity CFD.

4. Open your first position.

5. Monitor and close it.

Creating and Funding a Trading Account

Setting up a new account for your commodity CFD trading is quite user-friendly. First, choose your CFD broker and follow a few steps to open an account on their website. Once you’ve verified your account details with ID and proof of address, your broker provides you with instant access to all CFD markets.

Next, fund your account by connecting your credit/debit card or bank to your trading account. Use them to start your trading journey.

Developing a Trading Strategy

Next, create a trading strategy that can help you manage your risks and capital. A trading strategy can also help you plan for acceptable profits and losses. To trade successfully, use both fundamental and technical analysis to study the commodity market before entering a CFD position.

Choosing Your Commodity Market

Select the commodity you want to trade based on the strategy in your live account. Another great way to choose a commodity market is to follow global trends and hot news.

You can choose top commodities like gold, silver, and crude oil. If you have a bit more experience, you can also try other markets like coffee, cocoa, and sugar.

Opening Your First Commodity CFD Position

Based on your strategy, you can open a long (buy) or short (sell) position on one or more commodities.

Be sure to set stop-loss and limit orders for all your open positions. In case the trade goes against your prediction, you will only incur a small loss.

Monitoring and Closing Your First Position

Once you open your first position, you can monitor it over your chosen timeframe. You can keep your trading platform open on your PC or monitor it using your phone app. You can also opt to receive trade alerts through email, SMS, and push notifications.

If the position moves in your favor, close it and take your potential profit. If the position moves against you, you can still exit the position to avoid further loss and preserve your capital.

Final Thoughts

Commodity CFDs create opportunities for retail traders to speculate on commodity prices without purchasing them.

Source: Compiled