Introduction to Futures and Commodity Trading

Futures and commodity trading can be profitable, but do not try it without learning the basics first.

Some examples of what is traded with futures and commodity contracts are agriculture gold, silver, natural gas, hogs, cattle, orange juice, copper, oil and soybeans.

Futures are not like stocks where you can hold them forever, a futures contract does expire on some date. The futures contract is an obligation to fulfill the contract or sell it before it expires. There are two sides to each trade. The long position is the buyer of the futures contract. And the short position is the seller.

This is a contract, for example, in March you enter into a contract to buy your neighbor John’s tomatoes in July for $5. You and John have just entered into a futures contract. If the price of tomatoes goes up by July to $10, your neighbor has to sell you those tomatoes at $5, or you could sell your contract to your other neighbor Judy for $8 in June. If the price of tomatoes goes down to $3 by July, you still have to buy those tomatoes from John for $5 in July. And john has to sell the tomatoes at the July price in July when that contract expires.

The buyer of this futures contract is agreeing to buy the commodity at a fixed price from the seller of the contract. And the other side, the seller agrees to sell this commodity at this fixed price at the expiration of the contract. As time moves on the price of these contracts fluctuates. Different conditions affect these contract prices. For stock and currency commodities, interest rates and government policies can affect them. For agriculture and ranching commodities, the weather is a big factor.

Who trades commodity and futures contracts

Hedgers and speculators, the hedger is the business who will need the underlying commodity. For example Kellogg’s will know how much wheat it will need for its products on a certain date. They will then enter in a long contract and buy the futures on wheat. Delivery is when the actual commodity is delivered to the person or business. With Kellogg as the buyer, they would take the actual delivery of all that wheat. Hedging can also work with individuals. You have a large portfolio of stocks, you think the market is going down, so you sell the market, sell an S&P 500 contract and the market goes down. You lose money in your stocks portfolio but you gain the profits on your futures contract.

Speculators are traders who are trying to make money by judging the price movements of the commodity they are trading. Speculators have no interest in taking delivery of any of the commodities they trade. A lot of money can be made quickly in futures trading, and a lot can be lost just as fast. Commodity futures trades are highly leveraged with the trader putting up a small fraction of the cost of the trade, maybe 10 or 15%, this is called margin. This is good faith money, not a down payment. If the trade starts going the wrong way, the trader gets what’s called a margin call, where more money is needed into the account to bring up the margin up to the minimum maintenance margin, which can be different for each type of commodity.

Opening a futures trading account

You need to find a futures broker and then read and sign the agreement. Commissions aren’t expensive and depending on the amount of money in your account can be around $18 per round trip (a buy and a sell).

Example commodity and futures trades

Every commodity has a contract size. A few examples, one gold contract is equal to 100 troy oz. Wheat is 5,000 bu (bushels) and light crude oil is 1,000 bbls (barrels) or soybeans at 5,000 bu per contract.

In January you believe the price of soybeans is going to go up by mid summer, you decide to buy one July soybean contract. You put down the initial margin amount of $2,000. The current July contract is $7.00 and you buy one for a value of $35,000 (7 x 5,000 bu per contract). By April the July contract has risen to $7.50 and you decide to sell that one contract for a profit of $2,500 (.50 x 5,000 bushels). If the price of soybeans had gone down by .50, you would have lost $2,500.

Gold is $800; buying one gold contract would cost you $80,000. Remember, one contract is 100 ounces, $800 x 100 ounces = $80,000. Not many could afford to risk that or would they want to. With leverage you could enter this type of trade using just 10% of your money. So this one gold contract (100 ounces) would now put $8,000 at risk. This is an initial “investment” of $8,000 with $72,000 leverage. This 100-ounce contract will move $1,000 for every $10 move in the price of gold itself. (Price move x contract size, $10 x 100 oz. = $1,000).

With the actual money you have invested, this $10 increase in $800 gold is only a 1.25% increase. But the leveraged contract you have, the gain is 12.5% ($1000/$8000 = 12.5%). Remember you multiply the gains by 100 oz so the $10 gain x 100 oz = $1000 gain on your originally invested amount of $8,000. Now that’s quit a nice gain and that’s how leverage in futures trading can make you money fast.

You can lose it just as fast, instead of the gold going up, it goes down $10. And now with this leverage you have lost 12.5% just that fast.

The margin call

Your initial investment of $8,000 is called the opening margin. If your contract did lose $1,000 you would get a call from your broker telling you that you need to put more money into the account, maybe another 10% depending on the amount of the loss. You might be thinking no big deal, before my contract looses too much I will just sell. That is easier said than done, there are a lot of emotions that goes into trading, and selling. And sometimes you cannot sell your contract if it is lock limit. That is a rule you will need to learn about. Lock limit means that if a certain commodity gets to a certain price, it cannot be sold or bought, depending on the trading conditions.

Futures’ trading is not for the new trader or for those living on a tight budget. There is a lot to learn concerning futures trading including how each contract is traded, the underlying commodity, the different strategies and the closing out of your position.

There are numerous sites on the internet where you can practice trading commodity futures. You should look into those before you ever make a real life trade.

Sam Montana © 25 January 2009

The following web sites have training material as well.

Kansas City Board of Trade (KBOT)

Chicago Mercantile Exchange (CME)

Chicago board of Trade (CBOT)

New York Mercantile Exchange (NYMEX)

Forex, foreign currency trading

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Posted on Feb 2, 2009