Thanks to recent technologies, anyone who knows how modern trading works can trade in commodities. However, people should also be aware of the underlying risks.
Commodities are in fact products with a uniform price and quality made by a large number of producers. Commodities consist of several groups: energy such as crude oil or gas, metals – not just precious metals such as gold, silver, platinum or palladium but also copper – and also agricultural products. Corn, cocoa, coffee beans, meat, livestock or apple juice are thus commodities. Any commodity exchange has clear rules determining characteristics of individual commodities and their tradable amount.
Leverage product principle
Using the principles of leverage products, such as contracts for differences, is usual on commodity exchanges. If you have such a contract, the difference will be paid out at price movements. If the prices grow, the difference is paid by the buyer to the seller and vice versa if the prices go down.
Trading commodities using CFD and financial leverage is illustrated in the following model situation:
WTI crude oil amounted to USD 40.98 on 21 July 2020 at 8 am and USD 41.9 at 12 pm, which is 2.24% up. The table shows examples of trades with leverage. At present, a 1:1 leverage ratio is applied to crude oil trading through CFD; however, our model in the table also shows a possible profit/loss when using a lower ratio or no leverage in trading. It is speculation on price growth, i.e. if the price rises we generate profit, if it falls we incur loss.
*Fees: The table shows ‘spread’, a brokerage fee calculated from the trader’s profit as a difference between the buy and the sell price. For fees and details of the calculation, refer to the BCM documents.
The scenarios apply to a trader who opened his position at USD 20.31 on 21 July 2020 at 10 am and closed it at USD 21.07 on 22 July 2020 at 12 am. In this period, silver grew by 3.74%. The trader speculated on price growth as mentioned above. Without the financial leverage, the trader would possibly gain USD 374 at an initial investment of USD 10,000. The trade cannot be considered unsuccessful. Far from it. If the trader speculated on price decline, he would lose his money. Speculation on growth thus was an appropriate strategy in this situation.
Using financial leverage
Gains may be multiplied by using financial leverage. For example, at a ratio of 1:5, a trader in the same situation would generate a profit of USD 1,870. At a ratio of 1:10, which is now applied to silver trading, the trader would gain USD 3,740.
Capital markets are regulated in the EU and the maximum leverage in commodity trading is 1:10. Yet, bear in mind that leverage can lead to profits but also high losses. If the trader speculated on price decrease, he would incur a loss of USD 740 at a ratio of 1:10, which means that he would lose more than a quarter of the invested amount within 14 hours.
Leverage trading is a risky business and no credible institution offers it without a duly completed investment questionnaire. All potential clients interested in risk-bearing products are obliged to fill in the investment questionnaire.
History of leverage trading
Financial leverage was first used when McLean Industries, Inc. purchased Pan-Atlantic Steamship Company in January 1955. Today, we would call this transaction a leveraged buy-out. These buyouts were most popular in 1980’s. CFDs, as we know them today, originated in London in 1990’s. Brian Keelan and Jon Wood from UBS Warburg are referred to as their founding fathers.
The Internet which started developing in late 1990’s allowed for the monitoring of immediate movements in prices and instant trading. On these grounds, a number of new online platforms and mobile applications occurred, making trading easier.Go back