Why trade commodities?

Gold has historically been a safe haven asset in times of market uncertainty. Learn the benefits of gold and other commodities with our thorough guide.

Commodities are naturally occurring materials or produce that are the raw materials for the production of everything from food, energy and clothing to buildings and construction.

There are many reasons to start trading commodities. Gold is often used as a safe haven, especially in troubled times. Commodity prices may move independently from stocks, making them useful for portfolio diversification. Commodities can also provide a hedge against cash inflation.

In addition, many traders may trade commodities using commodity CFDs, mainly because access to leverage means they can trade large positions with a relatively small deposit and amplify their profits as a result.

Of course, increased leverage increases risk.

How are commodities traded?

Commodities are standardized for quality, which means they’re priced the same regardless of who produced them, allowing them to be bought and sold on exchanges, like stocks. Well-known exchanges include the Chicago Mercantile Exchange (CME), New York Mercantile Exchange (NYMEX) and London Metal Exchange (LME).

Commodities trading at these exchanges is based on the buying and selling of raw materials and the physical trading of goods. But commodities brokers also trade futures, to allow producers and consumers to secure financial stability and accurate financial forecasting.

This involves futures contracts.  Futures contracts are standardized agreements or contracts with obligations to buy or sell a particular asset at a pre-set price with a future expiration date. These were originally developed for producers and industrial consumers as a hedge against price increases or decreases, but also allow opportunities for speculation.

Commodities trading with CFDs

CFDs (Contracts for Difference) are a derivative instrument that can be used to trade commodities.

CFDs allow traders to speculate on the way the price of a commodity will change, without ever owning the commodity in question.

A CFD is a contract between a trader and a broker with a set end date. Traders who expect an upward movement in price will buy the CFD, while those who see the opposite downward movement will open a sell or ‘short’ position. At the end of the contract, the two parties exchange the difference between the price of the commodity at the time they entered into the contract, and its price at the end.

So if you opened a long (buy) CFD trade on gold when gold was priced at $1,500, and you closed the trade after the price of gold rose to $1,600, you would make a profit on the difference in the gold price, or $100. If the price fell to $1,400, you would make a loss of $100.

In practice, it's important to remember that your trading profit isn't simply the difference between the opening and closing price of the trade - you also need to consider the costs of trading.

In simple terms, the trader is paying the difference between the opening and closing price of the commodity they are trading. What makes CFDs exciting is the fact that you can also go short, allowing the potential to make a profit when the price of a commodity falls. Being able to make a profit in a falling as well as a rising market is particularly attractive when markets are volatile.

CFDs can be simpler than other financial instruments like options and futures. The relative ease of entering and exiting positions has helped make trading commodity CFDs popular, but there are a number of other benefits.

The first is the easy availability of CFDs. Commodities are traded globally, and traders can trade twenty-four hours a day, five days a week, accessing opportunities from a range of commodities and exchanges all around the world.

Perhaps even more important is leverage. This means that a trader can trade positions many times the amount that they have. Leverage is a key feature of CFD trading, and can be a powerful tool for a trader, who can use it to take advantage of comparatively small price movements, or simply make their capital go further. Leverage works by using a deposit, known as margin, to provide increased exposure to an underlying asset. It means putting down a fraction of the full value of the trade.

It can be a powerful way to increase exposure and potential profit, but it can also amplify losses.

What moves a commodity's price?

Commodity traders undertake fundamental analysis and technical analysis to forecast market movements. They aim to buy when the price is low, which is usually determined by an abundance of supply and falling demand. They sell when they believe the supply is outweighed by the demand, which can result in a profit.

Commodities prices are driven by the forces of supply and demand. Huge price swings can occur when scarcity or abundance of a commodity suddenly looks likely. These can be triggered by regular events, such as seasonal demand, or less predictable factors, such as a bad harvest, or developments in a particular industrial sector, a national or regional economy, or even global events.

However, unlike some other types of market, these factors can often be easy to see, understand and at times predict. This can help make commodities attractive for anyone with an understanding of the factors that will influence the price of a particular commodity.

Read next: How to trade commodities