Even though trading commodities futures offers enormous rewards, many traders are too intimidated to tap that potential. Fortunately, it's not complex to do.... and in some ways is easier than trading stocks or stock options.
What Are Commodities?
In terms of trading, commodities are precisely what the conventional interpretation defines them as... goods or materials that are the same no matter who produces, raises, or grows them. Some of the most common commodities include oil, natural gas, gold, silver, pork bellies, cattle, corn, and soybeans.
What Are Commodity Futures?
Futures are a way of buying and selling commodities without physically handling a truckload of cattle or bars of gold. Though some agricultural companies or oil refineries may intend to literally buy or sell corn or crude oil, speculative traders only intend to buy and sell futures- or more technically, 'futures contracts' - for a profit.
Futures, like stocks or stock options, are a liquid and organized way to exchange ownership or stakes that have constantly-changing value. For instance, a corn futures contract- which represents 5000 bushels of corn- may be worth $3.50 per bushel one day (or $17,500 for the whole contract), and then $5.00 per bushel the next week (or $25,000 per contract). The $7500 difference represents potential profit to the trader.
Note that not all contracts necessarily trade 5000 bushels (in the case of agricultural items) or 10 million btu's (in the case of natural gas).
Why Trade Commodity Futures?
While commodity futures contracts fluctuate in price, so do stocks, or options, and currency exchange rates- and each of those can be speculatively traded as well. So, why bother with adding commodity futures to a trading arsenal? The answer is leverage.
Sticking with the corn futures contract example above, while those contracts are worth $17,500 when corn's priced at $3.50 per bushel, the trader is only required to 'put up' $1688 per contract. Yet, if the contract does indeed move to a value of $25,000, the trader retains that entire $7500 profit.
That said, while the return on the actual amount of cash required to place the trade ($1688), the risk of loss is just as strong. Needless to say, an effective stop-loss strategy is critical.
How To Trade Commodity Futures
The mechanics of a commodity futures trade isn't unlike a stock or option trade. The instrument is selected, the current market price is generally known, and an expectation is in mind about where that contract will be valued in the future.
The only decision a trader will need to make is the expiration date of the chosen contract. Commodity contracts can be bought or sold before they expire, but they don't exist indefinitely- they will expire and become worthless eventually. For that reason, the trader should buy a contract that reflects the projected holding period. Longer-term contacts can cost more though (considerably more, in some cases), so it can be wasteful to buy more time than is actually needed.
There are usually a couple of years' worth of contracts available for most commodities, with a tranche of them expiring every three months.
Suggested Reading
- Commodity Future Margin Rates
- Chart Analysis Using Fibonacci Retracement Lines
- Basic Technical Analysis Candlestick Patterns
James Brumley - As a former stock broker and analyst, turned writer, James Brumley can tell you what most advisors can't - or won't. His belief is that ...
