The most commonly traded commodity is crude oil, and because of this, and the huge influence of fundamental factors, the oil market can be extremely volatile. Experienced traders can profit from rapid market movements, and therefore oil trading is particular attractive to investors.
When considering the price of oil, majority of people would assume that its value is the cost to buy oil barrels right now, as this reflects the nature of the standard retail environment. However, oil’s trading is in fact based on the future price of the commodity, bought from a specific location.
As part of an established trading strategy, investors have the opportunity to trade oil in several ways including on the futures market, and through financial derivatives such as contracts for difference (CFDs). Both trading styles have their own unique features, and in this article, we will take a look further at these forms of trading, and explain the differences and similarities between the two.
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According to the trading platform Plus500, the definition of oil future contracts is an agreement between producers and consumers to lock in a purchase price for a transaction at a later date. This is the most traditional way to access the commodities market and trade oil. These future contracts are legally binding, and as they are traded at a predetermined price at a specific time, they usually require a large amount of capital.
The rate agreed upon is regardless of the public traded value of a barrel of oil, which is beneficial to both the wholesale producer and consumer. With a commitment for the transaction to take place at a later date and at a set price, those involved can better manage their costs and expenses, and this is a strategy mainly used by the aviation industry, as an example.
Traders can also access the commodities market via CFDs, which are seen as an efficient addition to any investment portfolio. These are a financial derivative product, where the trade is based on the difference in value between the opening and closing of a position on the market.
CFDs therefore allow traders to speculate on the price movement of oil, without actual ownership of the asset itself. As you are not required to buy the oil outright at its spot price, CFDs mean that opportunities to trade the commodity are more accessible. They also involve leverage trading, which means that only a small amount of initial capital is needed.
The differences and similarities
For both oil futures and oil CFDs, the volatility of the oil market can lead to either a profit or loss, and so both types of trading require extensive research and knowledge of the financial instruments.
You will also have to monitor relevant geo-political and other fundamental factors that have an impact on the value of oil, as this will inform your trading decisions, and for either form of trading, you’ll then have to open or close your position accordingly.
However, the main difference between the two is how they are traded, as CFD trading is an over-the-counter (OTC) product, whereas futures contracts are generally traded on a domestic exchange.
Another notable difference is based on the fact that you can trade CFDs without owning the underlying asset, as this means that you do not require any storage, or have to manage the fees and maintenance responsibilities, as you would with an oil futures contract.
For an oil CFD, compared to oil futures, you will usually trade with leverage, as aforementioned. This means you place a deposit of a fraction of the full trade value, which gives you greater exposure to the market with the use of less capital. This means you can magnify your profits, but this also exposes you to greater losses as well.
Finally, with CFDs you have the opportunity to trade on both rising and falling markets, which means you can hedge your losses when you use them in your strategy with other methods of trading oil.