Spread betting is a great way to trade commodities over the short term. As well as offering exposure to a broad range of individual commodities and the opportunity to soup up returns by using borrowed money, it has two key advantages over other methods of trading: any profits made are free of tax and all trades are denominated in sterling, so there is no currency risk.
Let's look at a commodity spread bet in action. The London-traded cocoa contract expiring in September 2008 is trading at 1536-1542, the lower price being the price at which you can sell and the higher the price at which you can buy. You're bullish about cocoa, so you place a 'buy' bet – also known as going long – on the cocoa market at 1542 at £10 per point. To open a bet on London cocoa, you need to deposit 3 per cent of the total value of your bet with the spread-betting firm. The total value of your position here is 1542 x £10 = £15,420.
So, you'll need to have at least 3 per cent of this amount – £462.60 – in your spread betting account. In reality, you'll probably want to have more than this so that you have a cushion if the market goes against you.
You need to be psychologically ready for the big movements your spread-betting positions will experience. Chart 1 (see below) is a one-hour candlestick chart of soybean meal prices over a seven-day period. You may have entered the market at any time before points A, B or C, and would have probably lost money whether you were long or short because the market moved strongly in both directions, probably triggering your stop-loss order. The price range at point A was a whopping $35 on a $430 contract.
CHART 1: (E-TRADE) ONE HOUR CANDLESTICK CHART SOYBEAN MEAL
"Commodities trade in relatively different ways to other assets," says Angus Campbell, head of sales at Capital Spreads. "It's important to be familiar with what the market hours are for the commodity you want to trade. Many spread-betting providers widen their spreads during the more illiquid hours of electronic trading. Core trading hours tend to be shorter than for equities or indices, so you should be aware of this for the purposes of placing stop and limit orders."
When trading commodities, you also need to pay attention to when important news is due. "Find out when commodity-sensitive announcements are likely to happen," says Mr Campbell. "When the data released is not in-line with the market's expectations, big moves can happen very quickly indeed. A key event these days is the release of US oil inventories on Wednesdays at 3.30pm UK time."
Covered Warrants
A fantastic trading innovation of recent years is covered warrants. What's special about these structured products is the fact that they are geared – which gives you the chance to make big profits from small movements in the underlying commodity price – but, at the same time, you can't lose more than your starting capital.
Covered warrants are listed as fully tradeable securities on the London Stock Exchange. They can be traded in small size and are denominated in sterling. A 'call' warrant is used to buy and a 'put' warrant to sell.
The strike price is the price at which you will have the right to buy or sell the underlying commodity if you hold the warrant to expiry. Chart 2, below, shows SG Securities Brent Oil. This is the chart of a call warrant expiring on 10 November 2008.
CHART 2: (SG SECURITIES) BRENT OIL PRICES AND WARRANT PRICES
You buy the warrant in the same way that you buy shares. There are a number of warrants available and you will need to select one that is appropriate to your risk/reward profile. This will depend on the amount of gearing involved.
The effective gearing in this case is 3.1 times, which means that for every 1 per cent move in the oil price, the warrant will move 3.1 per cent. As you can see, the warrants’ price movement is closely correlated to the price of the underlying commodity. Gearing can vary from a very low two times to a very high 20 times. The gearing can also change over the life of a warrant.
Each warrant has a set expiry date, so it is very important for the expected move to happen before the expiry date. When starting out, it is useful to employ warrants that have plenty of time left until expiry, say four to six months, so that your trading strategy has time to come good. Shorter-dated warrants will be more volatile and therefore more risky. If the warrant is held to expiry, the cash value on the expiry date is paid to your account.
Note that the limited risk involved in covered warrants means you can never lose more than your original investment, unlike with spread betting or contracts for difference (CFD), or futures and options. That said, the gearing effect can easily wipe you out if the price moves against you too much. If the price of oil drops and you have a call warrant, your losses will be magnified. Using our previous example, for every 1 per cent move lower in the price of oil, your warrant’s value would drop by 3.1 per cent.
For covered warrants on dollar-traded commodities, the sterling-dollar exchange rate will affect the final payout price if held to expiry. There is no stamp duty to pay when trading covered warrants.
How to trade a commodity warrant
Even in a raging bull market, there is no room for complacency. Miss out on the move at an obvious price level and you may never see the same price again, at least not for a long while. But how do you get into the trade without getting burnt? These fast-paced markets have a common feature: the risk on trades increases as markets get higher because the risk of the reversal goes up, meaning that stop-loss levels are hit quickly.
Commodity markets are known for being especially mischievous. Professional traders and institutions know exactly where private investors place stop levels in a market and very often they are taken out or hit before the market swiftly moves higher again.
If you're taking a long-term view, short-term movements in the market may seem totally random and predicting the big move on a short-term chart is difficult. Placing your stop-loss for long-term trades is tough as the market may move in the opposite direction before taking off to the upside.
In these cases, enter into two simultaneous warrant trades, through which you can benefit from both the upside and the downside, eliminating the risk of the market reversing on you. With this strategy, you pay your losses up front. You enter into a long and a short position at the same time. Don't use CFDs or futures here because then the two trades effectively cancel each other out leaving you with no position at all. Instead, use 'call' and ‘put’ covered warrants, buying ones with the same strike price and expiry date.
Let's look at an example. Chart 3 (below), shows the price of silver over the past five years. The current price for silver is $18.77. There have been five major rallies of between 37 per cent and 116 per cent during the period. These lasted from four to nine months each.
CHART 3: (SHARESCOPE) ONE WEEK CANDLE CHART OF SILVER PRICES OVER FIVE YEARS
We can see that in any six-month period there is a high probability of a move of more than 20 per cent. To profit from this insight, you buy the $16 call for $1.925 and the $16 put for $0.427, both expiring on 19 December.
Your break-even point will be the strike price plus the premium paid for the call and the strike price less premiums paid for the put. This gives prices of $16 + $1.925+ $0.427 = $18.35 on the upside and $16 - $1.925 - $0.427 = $13.65 to the downside.
So, if you are to make money, the market has to move above $18.35 or below $13.65. The December expiry gives you six months for this trade to come good.
Looking at the historical moves, silver should have enough volatility to make this trade profitable. The only thing that remains is to lock in the profits by using a trailing stop-loss policy.
