Contract for Difference, or CFD, is the term used to describe an agreement between a broker and a trader regarding the change in the value of an asset over a period. The difference is where a trade is entered and exited, and this is known as the contract for difference. CFD’s have several advantages over other types of trades, resulting in an increase of their use over recent years.
What are commodities?
Commodities are a standard way to use CFD’s. These are physical assets and can include metals such as gold and silver, resources such as oil and gas as well as ‘soft commodities’ such as wheat, sugar or even cocoa beans. Commodities are known as the 5th asset class after the conventional asset classes – cash, fixed interest securities, property, and equities.
The commodities market is different to stock and currency markets. If the equity markets fall, for example, there’s nothing to say that the commodities market will do the same. Commodities tend to react very differently to conventional asset classes which makes them ideal for diversifying your investment portfolio.
What affects the price of commodities?
So, what can impact the price of commodities if they react differently to the other asset classes? Four main factors can have an impact – supply and demand, inventories and stocks, currency and inflation.
Supply and demand
If the supply of a commodity and the demand for it were perfectly balanced, then the price of the commodity would remain unchanged. Let’s use sugar as an example – if a farmer could grow the same amount of sugar each year, and the demand for that sugar remained the same, the price wouldn’t move. It would mean the farmer can not charge more for the sugar, but he could lower the price to increase demand over other farmers. But, if he can not meet the demand created, then the consumer would simply go to another farmer and pay more.
Inventory and stocks
Let’s say it has been a dry year and the farmer has only grown half of his usual amount of sugar. But, people still need sugar for their coffee and their cakes. No-one knew the dry spell was coming and therefore no-one had stocked up – there’s a shortage. Prices go up. On the other hand, if shop owners had realised it was going to be an arid summer and stocked up ahead of time, then the price may remain unchanged because there’s enough go around and another crop coming.
Currency and inflation
The other two areas have less to do with the actual commodity and more to do with more significant external factors. Exchange rates can impact the price if you are exporting or importing a commodity from one currency area to another. Likewise, if the government increases inflation, then everything will rise in price in line with the cost of living.
Why CFDs work for commodities
CFD traders never own a commodity but, instead, use their experience and judgement to decide whether the value of a commodity will go up (going long) or down (going short). If the trader is correct in their prediction, then the seller pays the difference between that initial price and the new value of the commodity. But, if it goes the other way, the trader will be expected to pay the difference.
Commodities are less volatile than some other asset classes, making CFD an excellent way to start trading, especially if you have a limited funds. Olsson Capital offers a range of the best CFD trading tools to help you make the most of your trades as well as a range of educational resources. Start trading today with Olsson Capital.