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Commodities and short-term traders

FEATURE: There are lots of ways to profit from rising and falling prices without buying shares or funds, says Dominic Picarda

Commodities have long been a favourite market among short-term speculators. Because they're often volatile, there are plenty of opportunities to grab a quick-fire profit. But as well as being prone to big moves, they often also behave repetitively at certain times of the year, making them popular among traders who follow seasonal strategies. Think of Eddie Murphy short-selling Orange Juice futures in the classic 1980s film Trading Places – "Buy, Mortimer, buy!".

Not all that long ago, trading commodities was largely the preserve of big institutions and wealthy individuals, as portrayed in that film. Nowadays, though, pretty much anyone with a few hundred pounds can speculate on moves in gold, oil and a whole raft of other commodities. In fact, the choice of ways you can do so may seem a bit confusing. How do you know whether to use spread bets, contracts for difference (CFDs), fixed-odds bets, leveraged funds or other listed products, or some other method?

The answer will depend on your own particular circumstances. You may, for example, wish to run bigger risks in order to achieve higher returns. Or, you may want to trade an instrument where you know exactly how much you stand to gain or lose right from the outset. Perhaps you would rather not pay tax on any profits you make, or perhaps you'd prefer to accept taxation but be able to offset losses against profits elsewhere. And maybe you're interested in trading something over a few months, rather than a few hours. Whatever your tastes, there should be an instrument to suit you.

Spread betting

My personal favourite way of trading commodities is via spread bets. They're straightforward, tax-free, quoted in sterling and can be traded from just a few hundred pounds.

Say gold is at $1,450 and you think it will hit $1,470 by the end of the week. You place a 'buy' bet at 50p a point. This means that for every 10¢ that gold rises or falls, you'll make or lose 50p.

In total, your position is worth £7,250. But you don't need to have £7,250 in your account. A spread betting firm might let you control that position with just £725 in your account. The rest you'd effectively be borrowing and you would pay a small daily interest fee upon.

If your hunch is correct and gold rises to $1,470, your profit is $20 or 2,000¢ x 50p = £100. Had it fallen $20, you'd have made the same-sized loss.

Notice that the bet takes place in pounds, even though gold is quoted in dollars. This is different from CFDs and futures, where you're trading in dollars. What can happen when trading in another currency from your own is that you make a 2 per cent profit on the commodity and a 3 per cent loss on the foreign currency, leaving you with an overall loss even though you were right about the commodity.

Any profits you make from a spread bet are free of capital gains tax. That's because they're legally classified as bets rather than investments, even though they work similarly to CFDs and futures. The flipside of this is that you can’t write off any spread-betting losses against capital gains on other assets.

Contracts for difference

CFDs function in very much the same way as spread bets. The main differences are that they are quoted in the currency of the commodity rather than pounds, and any profits may be taxable.

Why on earth, then, would you choose taxable CFDs when you can trade tax-free spread bets? Just as any profits you make on commodities via CFDs will be potentially subject to tax, you can also write off losses against gains elsewhere. For a lot of more serious traders and investors, this is a worthwhile attraction.

And because CFDs are classed as investments, you can hold them within wrappers that won't accept spread bets. For example, some providers of self-invested personal pensions (Sipps) will allow you to use CFDs in your Sipp, either to spice up your returns or to hedge your existing exposure in some way.

Futures

The main way to trade commodities is – and always has been – via futures. Futures contracts work in a very similar way to spread bets and CFDs. Unlike those instruments, the contracts are directly linked to the underlying commodity. In theory, if you bought one contract for wheat for June delivery and let it run until the expiry date, you could end up actually owning 136 tonnes of wheat.

Contract sizes are much larger than for CFDs or spread bets. For example, while you could easily trade a mere five ounces of gold worth just £7,250 via a spread bet, a single Comex gold futures contract is 100 ounces, or about $145,000 at current prices.

Futures are the most liquid way to trade commodities. This means you should enjoy a narrower difference between the prices at which you buy and sell – the 'spread' – than with spread bets or CFDs. So, for a very wealthy trader wanting to trade large amounts as efficiently as possible, futures are probably the best way forward.

Covered warrants

With spread bets, CFDs and futures, you can end up losing a lot more than your initial investment if the commodity you're trading moves strongly against you. Not so with covered warrants, however. Covered warrants are specially designed products upon which your maximum loss is the amount that you paid to buy it at the beginning.

Despite this element of protection, you can still make big gains from small price moves. It is quite possible, for example, to turn a 10 per cent move in a commodity into a 100 per cent profit – or loss. Covered warrants are 'geared' by varying amounts, typically between four and 10 times, meaning that profits and losses are multiplied by those amounts.

Another attraction of covered warrants is that they trade on the London Stock Exchange, like ordinary shares. So, you can see their price being constantly updated in real time, and deal them whenever the market is open. Unlike shares, you don't have to pay any stamp duty, although you may have to pay capital gains tax on any profits.

Covered warrants are a bit trickier to understand than the likes of spread bets and futures. If you think a commodity's price is going to rise, you buy a call warrant and if you think it is going to fall, you buy a put warrant. However, there's more to think about than simply the commodity's direction. You also need a clear view of what price it's likely to reach and when it's going to get there.

While there are usually quite a few covered warrants covering the most mainstream commodities like crude, copper and gold, the selection when it comes to lesser ones like palladium and the agricultural commodities can be much less impressive.

Fixed-odds bets

While much less well-known than spread betting, fixed-odds financial betting offers another interesting way to earn tax-free profits on commodity price movements. It allows traders to speculate on many different price outcomes, not merely movements up or down. For example, you can make money from a price touching two particular levels, one above the current price and one below it. Or, you can do a trade that will pay off if the price never reaches a particular level during a certain period.

The great beauty of this is flexibility. A good fixed-odds betting provider will let you specify the exact terms of the commodity trade that you want to do. For example, you might type in to a provider's website that you believe gold will remain between $1,450 and $1,500 over the next two weeks and never touch either price during that time. The provider will then quote you a fixed-odds return that you'll receive if you decide to place the trade, say 100 per cent.

As a result, you know exactly how much you stand to win or lose before you even place the bet. If you're right, you get the return promised to you by the fixed-odds provider. And if you're wrong, you simply lose your stake, or part of it if you decide to end the trade early.

As well as the potential to make big returns while taking limited risk, fixed-odds trading doesn't require a big trading pot. You can stake as little as $1 on a particular outcome, making it a good way for beginners to trade the markets. While most trades tend to be short-term – a day or even less – you can bet for periods of up to one year with these instruments.

One drawback of fixed-odds betting is the lack of commodity markets covered. It's rare to find prices offered on anything other than the most mainstream assets: gold, silver and crude oil. Also, there are very few providers and the lack of competition means that pricing is sometimes not as keen as it could be.