Using Contracts for Difference (CFDs) to gain exposure to commodity prices is very popular, but are you ready? In this article, we will take a look at some of the basics regarding commodities and the modern commodity markets of today.
Examples of commonly traded commodities:
Commodities that are mined, such as gold and crude oil, are known as hard commodities.
Examples of derivatives that are available based on various commodities are futures contracts, forwards, swaps, and options on futures.
It is not only speculators that use derivatives, Many commodity-growing farmers do for instance utilize derivatives to protect themselves against sudden price swings on the commodity market, and the same is true for many companies that depend a lot on the price of a certain commodity. For a chocolate bar manufacturer, a sudden rise in cocoa prices could be detrimental, so derivatives are used to create a more stable financial situation.
An exchange-traded fund (ETF) is a fund where the shares are traded on an exchange. Exchange-traded funds based on one ore more commodities have been available since the early 2000s.
A commodity index fund is a fund where the assets are invested in order to track a commodity index. The common index-type of choice is the commodity futures index.
The first commodity index was the Dow Jones Commodity Index, which was established back in 1933.
Examples of other well-known commodity indices are the Goldman Sachs Commodity Index, the DJUBS Index, the Rogers Index, and the Reuters / CRB Index.
Exchange-traded commodities (ETCs) are a type of asset-backed securities created to repackage the value of commodities. ETCs are traded on stock exchanges, and can be based on one or more commodities. The performance of an ETC is based on commodity spot price or tied to futures contracts. An ETC will typically attempt to track the daily performance of the underlying commodity or commodities.
The ETCs is convenient for traders who want to gain exposure to a commodity price without doing spot trading or traditional derivatives trading. Unlike Exchange-traded Funds (ETFs), the ETCs are debt instruments (notes) and the commodities serve as collateral for the note.
ETCs have become especially popular within the European Union, as mutual funds based there are not allowed to invest in single commodities or a basket of commodities that is not sufficiently diversified.
ETCs are available for a wide range of commodities and commodity baskets, e.g. metals, agricultural products and energy.
Exactly how an ETC is structured vary depending on the issuing company and the exchange. The London Stock Exchange does for instance require a specific structure in order to allow an ETC to be listed there.
An inverse ETC is a complex instrument create to move up when the underlying commodity moves down, and vice versa. It is thus a way of betting against the market.
A leveraged ETC is structure to multiply each movement of the underlying commodity by a specific factor, e.g. 2x or 3x. This makes it more volatile than the underlying commodity.