How to Commodities. What are commodities? What are futures? Are they the same? The short answer is yes. Some may argue that they mean subtley different things, but for the majority of intents and purposes they are one and the same, but at the very least they are interrelated.
Technically they could be construed differently but I believe, as do many others that they are the same thing. So what are commodities? Commodities are defined as a primary agricultural product raw material that can be bought and sold, such as silver or wheat.
Although commodities have been traded as far back as 17 century Japan where rice tickets were traded, the US commoditiy markets started in 1848, which is the year the CBOT, Chicago Board of Trade came into being. .Commodities are also known of as derivitives.
Commodity markets or futures markets were set up to help the farmer of the commodity which initially was only grains, specifically corn, wheat, and soybeans.
The idea is that if the price today is acceptable to the farmer of a commodity, but he will not be able to deliver his crop for months down the road, he can lock in a price that he can make a profit with by utilizing the futures market.
The farmer sells futures contracts for delivery in the future for the equivalent amount of his expected harvest. So, even if the price of the commodity goes down in the mean time, he is assured of getting his price when he is ready to harvest and sell his crop. This is also known as hedging his risk.
The negative aspect for the farmer by hedging his risk with futures is that the price he agrees on will be the most he can realize when he is ready to deliver.
In other words, if the price of the commodity that he provides goes above the price he agreed to, he will lose out on the extra profit.
Now, if he utilized options on futures, he could participate in an upswing in prices.
Only 3 percent of futures contracts traded are transacted by those that actually provide the specific commodity. The rest, 97% are traded by speculators, or investors. Speculators or investors are those that are looking to make a profit by trading commodities/futures.
Futures are often used by financial managers that have or manage large financial instrument portfolios in order to offset their risk, and maximize their return potential.
The sad truth is that only 15% of farmers use the commodity markets at all. This is despite the fact that these markets were designed for them, and can greatly enhance their ablity to stay in business and to prosper, if utilized properly.
A common denominator among many farmers that have been unable to maintain their farms, is they did not take advantage of the commodity/futures markets.
Speculators provide a very important service to the smooth operation of the futures markets. They provide liquidity. This liquidity allows for the ability to buy or sell futures easily as another speculator is there to take the other side of the trade.
Speculating in futures is a very risky proposition. It is estimated that 90% of investors lose money in the futures markets. 90%! However, many people have become very wealthy from trading these markets. These markets are highly leveraged, which means a small amount of money can turn into a large loss or a large gain.
Bottom line is, you better know exactly what you are doing before you tread here in commodities. My intention is not to scare you away from futures, but to make you understand people can and do lose money.
In order to learn how to trade futures we must first understand more about them. There are two main types of futures. Futures that are traded for physical delivery are the agricultural types such as corn, wheat, soybeans, and others.
Financial futures, on the other hand, are settled in cash, or cash delivery. These types include stocks, bonds, indices, currencies, and others.
Futures are traded at commodity exchanges. The most well known, and largest of which is the Chicago Board of Trade, or CBOT. The Chicago Mercantile Exchange, also known as the Merc, is also a well known, heavily utilized exchange.
There are also commodity exchanges in New York, Philadelphia, Kansas City, and elsewhere in the U.S. Many other countries also have exchanges where futures are traded.
Within these exchanges are pits or trading areas where a specific commodity is bought and sold. If you have ever seen one of the trading pits in action, it looks very chaotic, and unorganized. In reality though, it is anything but chaotic, and unorganized.
The traders in these pits are placing orders that come primarily from commodity brokers for their clients. These clients can be speculators or those involved in the underlying commodity such as farmers, grain merchants, and others.
Speculators or investors utilize many of the commodity trading tools that their commodity brokers supply. These trading tools include both technical, and fundamental information about a specific commodity.
Technical tools include charts that show prices, open interest, volume, moving averages, convergence/divergence, and other indicators.
Fundamental analysis includes news reports, farm reports, weather reports, and other information that can affect the supply and demand, outlook, and prices of a certain commodity.
Speculators normally use a combination of technical analysis, and fundamental analysis, to guide them in their trading decisions.
Important commodity/futures trading terms:
Contracts: These are what are bought and sold in the futures market and represent a certain quantity of the commodity that is traded.
Volume: represents the total amount of futures contracts that have been bought, and those that have been sold in one day.
Open Interest: the total amount of pending or outstanding contracts that are currently held by those in this market at the end of the day.
The various commodities that have futures markets include (heaviest traded):
Agricultural: rice, corn, wheat, soybeans, soybean oil, oats, cotton, coffee, sugar, orange juice
Livestock and Meat: live cattle, feeder cattle, lean hogs, pork bellies
Energy: heating oil, crude oil, gasoline, natural gas
Metals: gold, silver, platinum, palladium, copper
Commodity brokers are the folks that facilitate the trades that all traders make. There are full service brokers, discount brokers, and those that provide both full service, and discounted brokerage services.
Brokers have different rules, and qualifications for their clients. Normally, the full service brokers will provide many tools, and also help you with determing which trades to make.
The online discounted brokers may have some tools to assist you, but you are on your own when it comes time to decide what, and when to trade.
Some brokers may even let you place dummy trades, where no money is at stake but the conditions are the same as with a normal trade.
There are different fees involved with brokers. Even discounted brokers may have additional fees, so make sure you know and understand how you will be charged before you open up an account with any broker.
Commodity trading used to be the playground for the rich, and it still is, however, it is now possible for those with less substantial means to trade commodities. Some exchanges offer ‘mini contracts’ that require smaller monetary commitments than the typical futures contracts.
Also, trading options on futures can be less risky and less expensive than trading actual futures.
If you are just getting started with commodities, and you have a strong interest or passion in this exciting area, I strongly suggest you invest in your commodities education before you even consider becoming a trader.
You will be better served to spend money and time learning the ins and outs until you feel comfortable with futures, before you spend money on actual trades.
You can request basic commodity trading learning materials from many brokerage firms free of charge. You can of course also go online to find many excellent commodity education sources.
I suggest you try to find a mentor that has been, and is successful doing what you want to do, making money trading commodities.
The very best mentor that I have come across is the great Larry Williams. He is one of the most knowledgeable, and successful traders in this arena, and he has many years of experience.
Larry forgets more about commodities/futures than I know. He has written books, has online courses, and has a membership program that has a lot of members.
A trading coach may be the optimum way to learn to trade commodities. In order to take advantage of a trading coach, you should have a good, basic foundational knowledge of commodities going in.
Find someone that is already successful doing what you want to do, and emulate them. Knowledge is power.
From Humble Beginnings to High Finance
The commodity markets started as a way for a farmer to sell his crops at a local market. They slowly evolved to include futures as a way for him to hedge his risk.
As time went on, more types of farm products were added in these markets. Soon other farm products such as cattle, and hogs were traded in the commodity markets.
Eventually energy products like crude oil, and metals like silver, and gold were included in the futures markets.
Today a myriad of financial instruments are also traded in the futures markets in exchanges all over the world.
Despite the fact that commodity markets were brought about to benefit the farmer, only 15% of farmers use these markets to assist their business.
Only 3% of all the contracts traded, are by those that perform delivery of the commodity. The other 97% of contracts bought and sold are done so by speculators.
Speculators normally use a combination of fundamental analysis, and technical analysis to determine what, where, and how to trade.
Commodity brokers provide various services to facilitate trades for their clients. There are discount online brokers that provide little support, and charge smaller fees, as well as full service brokers, usually off line that provide a good deal of support in exchange for larger commissions, and other fees.
In this highly risky playground of the rich, it is wise to educate yourself thoroughly in commodities, and futures, before you attempt to undertake an active trading strategy.
How to Commodities