Ways to trade commodities
Commodities trading, while sharing some similarities with currency and stock markets, possesses some distinct qualities that make it worth educating yourself before diving in.
To get started, let's examine the main ways to trade commodity markets: futures, options and CFDs.
Commodity futures are contracts in which you agree to buy or sell a set amount of a commodity for a set price on a set day. Futures are an extremely common way of speculating on commodities, as their prices move up or down in line with the underlying asset.
Originally, futures were intended to help producers safeguard their revenue streams against dramatic price fluctuations, but now most futures trading volume comes from speculators as well as hedgers.
For the most part, futures contracts don't result in the physical delivery of the asset, as traders choose to settle their position in cash or roll over the trade to the following expiry date.
Example of a commodity futures trade
You believe WTI oil is going to rise from its current market price of $65 per barrel. So, you buy a futures contract for 100 barrels of oil at $70 each, with an expiry for one month.
As the end of the month approaches, the price of WTI has risen to $75 a barrel, and you decide to close your position. Your contract means you can buy 100 barrels of oil at $70 each, rather than the current market price.
This means you've saved $500 ($5 x 100). If you didn't want to take ownership of the oil, you'd just settle the position in cash, or sell the contract on to someone else.
However, if the price of WTI had remained the same or fallen, you'd have to close your contract at your chosen price of $75, which could be much higher than the new going rate – meaning you'd make a loss on the position.
Commodity options give you the right, but not the obligation, to trade an underlying asset at a specific price – called the strike price – before the option expires. To get this right, you pay a premium.
There are two types of options: calls and puts. Calls give you the right to buy a commodity, while puts give you the right to sell a commodity.
In options trading, the risk is limited for the buyer and the profit is potentially unlimited. This is because when you buy an option, you have the right to let your option expire worthless. Unlike when you trade a future, you can choose not to execute your trade.
If you don't execute your trade, then all you lose is the premium you paid for the option.
You can sell options as well as buying them. This is known as writing.
- Selling a call option means you're giving the buyer the right to buy a set amount of a commodity from you at a set price.
- Selling a put option means you're giving the buyer the right to sell a set amount of a commodity to you at a set price.
As a seller of an option, you're always guaranteed the premium charged to the buyer, regardless of whether they execute the trade or not. But your risk is potentially unlimited, as the market could move well beyond the strike price before the option is executed.
Most commodity options take their price from futures markets, rather than the underlying asset itself. This is important to be aware of, as you'll need to keep an eye on futures pricing.
Example of a commodity options trade
You believe that Soybeans are going to fall from their current market price of $14 per bushel. So, you decide to buy a monthly Soybean put option with a strike price of $12 – the current premium for which is $0.75 per bushel. As Soybean futures are traded in lots of 5000 bushels, you'd have a total premium to pay of $3750.
The price of Soybeans does fall by the option's expiry and is now trading at $11 per bushel. At this price, your put option would be in the money and you could execute it for profit. You'd get to sell 5000 bushels of Soybeans at $12 each, rather than the new rate of $11.
Once you take the premium into account, your total profit would be $1250, or $0.25 per bushel.
However, if the price of Soybeans had risen to $15 instead, you'd be looking at a loss of $3 per bushel – a total of $15,000. In this instance, you could let your option expire and only lose the $3750 premium.
Like futures and options, CFDs are contracts. With CFDs, though, your contract enables you to exchange the difference in a commodity's price from when you open your position to when you close it.
When you trade commodity futures with us, what you'll be getting is a CFD position on the underlying futures market.
You won't be entering into a futures contract yourself, but rather speculating on whether the price of futures will rise or fall before the date of expiration. The more the market moves in your favour, the more money you make – but the more it moves against you, the more your losses will stack up.
Commodity CFD example
Let's say you'd bought a US Crude Oil CFD Future – our market for WTI – believing the price of oil will rise in value.
If your prediction was correct, and the market did rise, your profit would be calculated based on the difference from when you entered the position, to when you closed it. So, if you entered the CFD at $65 per barrel, and closed it when the market reached $75, the market would've moved $10 in your favour.
However, if your prediction is incorrect, and the market moves against you instead, you make a loss.
Spot commodity trading via CFDs
With FOREX.com, you can also choose to trade CFDs on spot commodities.
The spot market is the simplest form of trading. It's where commodities are bought and sold for cash, and the exchange takes place immediately – or 'on the spot'. Traditionally when using the spot market, you'd physically take ownership of the commodity you've exchanged, but it has become used for speculation and hedging – just like futures.
Our spot markets are non-expiring, meaning they do not have a set expiry date, so you won't be subject to rollover charges. Spot prices give you the opportunity to trade commodities long-term without the need to roll your position on expiration.
These markets are priced using the underlying futures contract. But unlike futures price charts, which are confined to their expiry periods, our spot markets have continuous charting. This enables you to perform technical analysis with larger quantities of historic data.
Test your knowledge
- A In cash
- B Roll it over
- C Physically
- A Future
- B Option
- C Spot