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Trading Commodities with CFD's

CFDs are complex instruments and come with a high risk of losing money rapidly due to leverage. Between 74-89% of retail investor accounts lose money when trading CFDs. You should consider whether you understand how CFDs work and whether you can afford to take the high risk of losing your money.

Everyday market participants from around the world are involved in buying or selling currencies for different purposes: to speculate for a profit or simply to execute client's orders. Retail traders are only a small part of this world, as most trading is being done by commercial and central banks, institutional investors, high-frequency trading algorithms, etc.

Nevertheless, financial markets are so big, that the trading volume on a daily basis is huge. Everyone has a place to trade and this gives liquidity to financial markets.

To trade a financial instrument, one needs a broker. The brokerage house is offering various instruments to trade, and the ones that are the most representative are the currency pairs.

However, there is a stiff competition among brokers to gain as many customers as possible and to retain them over the long run. To do that, different financial products were added to the standard offering.

Commodities and CFD's

To avoid depending on a single market, like the Forex market, brokers started to offer other financial products that can be traded. Such products are commodities (gold, oil, silver, cotton, etc.,) and CFD's (Contracts for Difference).

Commodities are bought and sold daily, exactly like currency pairs are, but they have different factors that influence their movements. If, in the case of a currency pair, the interest rate differential is the thing that makes the difference between buying or selling a currency, in the case of commodities trading supply and demand plays a crucial role.

To further extend their offering, brokers introduced the possibility of trading commodities with CFD's. Before looking at the advantages and disadvantages of trading such a product, let's have a short look at what a CFD is.

As the name suggests, a CFD is a contract for difference and the name says much about how to make a profit trading this product. For example, if one is buying a CFD on any given financial product and the price of that product moves to the upside, the difference between the entry and exit price is positive.

That difference represents the profit. On the other hand, if the price is moving to the upside, by the time the trade is closed, the difference is negative and it represents a loss.

Advantages of Trading Commodities with CFD's

The commodities market is a very special one. It is not like the currency market, where there is huge liquidity, and all buyers can easily find a seller no matter the trading volume.

Depending on the commodity one wants to trade, buying and selling are more difficult to be made. Probably on the most liquid commodity products like gold, oil, and silver, the trading volume is not such a problem.

However, on other commodities, like cotton, cocoa, palladium, iron ore, etc., liquidity may be a problem. To avoid such constraints, a CFD can be used as a vehicle to profit from the way a commodity is moving.

Therefore, a CFD is offering access to markets that do not have much liquidity and are not offered by brokers. One cannot trade cocoa on any broker but can trade a CFD based on the cocoa price on most of the brokers.

Another advantage when trading a CFD is the fact that one can buy (go long) or sell (go short) without literally owning the product. It is like in the case of the Forex market, when buying and selling is being done in margin and with leverage.

Margin and leverage are part of CFD trading as well, and this is both a blessing and a curse. It is a blessing as it gives traders the possibility to move bigger quantities of that product, but in the same time, the risk grows exponentially.

Disadvantages of Trading Commodities with CFD's

One of the biggest disadvantage when trading a CFD is the margin needed for a trade. As a rule of thumb, the margin requirements are bigger than when trading the regular Forex market.

In the case of a commodity based CFD, these margin requirements are even bigger. To give you an example about what margin means, imagine one is funding a trading account with $1000.

If the trader decides to trade a gold based CFD or a currency pair on the spot Forex market, the margin needed for these two trades is different. This margin will be blocked by the broker until the trade is closed: either reaching the take profit or the stop loss.

It means that all the time the trade is open, taking other trades is limited by the free margin that remained in the trading account. Therefore, continuing with the comparison, there are fewer simultaneous trades possible when trading commodity based CFD's than when trading the classical currency pairs on the Forex market.

This, somehow, limits the possibilities the trader has. However, this can be easily overcome by simply having more funds available for trading.

The biggest drawdown when trading commodities with CFD's and when trading commodities, in general, is the fact that their price is moving based on different factors other than the ones that influence the currency market. And this is something many traders fail to understand.

Commodities are paired with the U.S. dollar or another currency pair to compare the way price is moving in time. The biggest mistake of them all is to trade a commodity based on what the dollar implications are for it. Again, this is not the currency market, where the dollar has a crucial role as the world’s reserve currency. A commodity represents a special market, dominated by other factors that are more important than what is happening with the interest rate on the dollar.

Having said that, it is not surprising to see the U.S. dollar strengthening across the board in one period, but gold, for example, to move to the upside all this time. Gold denominated in dollars is listed as XAUUSD, so you may see the dollar moving to the upside against a weighted currency basket, but to the downside against gold. All in all, trading commodities in general and with CFD’s in special has both advantages and disadvantages. Knowing what moves the commodities markets is key for taking the right trading decision and profit from these products.

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CFDs are complex instruments and come with a high risk of losing money rapidly due to leverage. Between 74-89% of retail investor accounts lose money when trading CFDs. You should consider whether you understand how CFDs work and whether you can afford to take the high risk of losing your money.

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