This article about commodities trading is applicable worldwide unless stated otherwise. Investing in commodities is a risky and speculative activity, which may cause you to lose more capital than you originally invested due to the ‘leverage’ inherent in commodities trading methods.
For high risk investments of this nature; you should only risk what you can afford to lose without affecting your current or future quality of life.
Any companies mentioned in this article have not paid Financial Expert in return for their feature and were included purely as the result of financial journalistic research.
What is Commodities Trading?
Trading in commodities is an active trading strategy. The term ‘trading’ implies actively buying and selling investments with successful timing.
This is contrary to the ‘buy and hold’ philosophy of investment, which promotes owning assets which produce positive cash flows and capital gains for long investing time horizon of time (5 years +). If you are interested in taking long term positions in commodities, then read our ‘How to invest in commodities‘ article.
How to Trade in Commodities?
How to trade in commodities is not as complicated as you might think.
Several options are available to newbie investors looking for a way into this exciting but volatile marketplace; Spread Betting, Derivatives Trading and Physical Ownership.
Spread Betting On Commodities
Read our guide to spread betting article for more information on this indirect and relatively efficient commodities trading method. I will provide a summary here to allow comparison against other commodities trading methods.
Spread betting is done through a financial spread betting platform, provided by a specialist financial bookmaker (E.g CMC Markets), bank or broker (E.g. Natwest Stockbrokers) or large bookmaking brand such as Tradefair. Whilst the user interfaces will differ, commodities spread betting will work the same with any provider. Investors wager a nominal amount against each point of movement in the underlying asset or indexes value. An example would be £10 per point in the movement of the gold spot price.
The low margin deposits required against a wager introduces leverage into the equation, either magnifying returns or increasing losses.
Betting providers allow you to bet on the futures price of a commodity. Many different futures contracts exist at any one time depending on the month the contract will close in, meaning many different prices may be quoted. Ensure you understand which contract you wish to bet on. The nature of this tweak means that one cannot place a bet indefinitely on the price of a commodity – the bet will eventually close when the futures contract reaches execution date.
Spread betting allows for tax-free gains on the closing of bets, this is because spread betting is a form of gambling and is therefore exempt.
Spread betting does not have a positive expected return, as you are in-fact betting against the house. By offering unfavourable price points, the betting provider is able to take an opposite position against you or pit you against other traders placing opposite bets. Either way, the pot of money being fought over is finite, so only a minority of betters can win.
Commodities Derivatives Trading
Once the preserve of investment bank backrooms – derivatives are now available to trade from the comfort of your own home. In our structured products guide, we explained how derivatives are used to create ‘user-friendly’ investments with complex characteristics. But they’re also sold directly to investors in some circumstances.
In essence, a derivative is a contract between two parties whom agree on given transfers of wealth between the two, the outcome of which depends on an underlying asset.
Examples of derivatives are futures, options and swaps. Derivatives can be difficult to value, as well as understand the intricacies of how the market works. Therefore I recommend that beginners or amateurs to investing do not consider using such tools early in their investing career. Derivatives are only appropriate for financial experts and those with a high risk appetite.
Even the veterans should show caution, dipping their toes in slowly as to ensure they invest their money wisely.
Large stockbrokers offer derivative access to the retail investor. An example is my own broker TD Direct Investing which exists in the UK. Opening a derivatives account is as easy as a savings account, as you can see from the screenshot below:
Trading in Commodities
As TD Direct Investing’s literature goes on to explain; it offers trading on “450 instruments” (450 futures contracts) in various commodities including oil and energies, base metals, precious metals, bonds and meats. I was surprised when I first discovered the range of instruments available for retail investors to trade, without the need for specialist software or know-how.
Perform your own research with a stockbroker of your choice to see what range of derivatives they have on offer. Compare fees and spreads between different providers, because your favorite stockbroker might not necessarily offer competitive rates for different types of trading.
I have touched upon physical ownership of commodities in my How to invest in Commodities guide, as well as other articles, including my list of commodities you can invest in.
Physical ownership of commodities is only feasible with commodities that do not perish and can store value efficiently by size or weight. Only precious metals fit these criteria. This is the reason why there are a multitude of ways to invest in gold, but only limited ways to invest in industrial materials.
This, therefore, excludes oil, all soft commodities (those that are grown) and industrial metals such as aluminium and copper. What would you do with £20,000 of cotton or frozen orange juice?
Physical ownership has the merit of simplicity on its side. If you expect that commodity prices will increase, you can take possession of gold bullion coins and sell these if their value appreciates over the years.
There are drawbacks to such a simple approach; physical ownership does not allow you to take a short view on the price of precious metals, as you cannot ‘sell short’ in the gold bullion markets without resorting to derivatives or brokerage accounts again.