The Commodities Markets and You
Think about it. Commodities infuse just about all aspects of our lives. The cotton in your shirts and socks trade on the futures markets. The corn in your cereal bowl flakes, even the milk you poured over it, actively trade on the Chicago Board of Trade and the Chicago Mercantile Exchange.
You arrive to work in the morning powered by a vehicle running on gasoline and maintained with 10 W40, having just left your home heated by natural gas and cooled by electricity. Or it may be heated by home heating oil and cooled by natural gas. Either way, these are all actively traded commodity contracts. Did you put soy sauce on your egg rolls last night? Well, you get the picture.
The commodity markets originated so that farmers could sell forward their harvest even if current demand lagged for their product. This was much better than seeing thousands of bushels of corn waste on the side of railroad freight docks. The past thirty years have witnessed the evolution of these markets to include banks hedging their loan exposure with bond futures and portfolio managers utilizing index futures to insulate client accounts.
Besides commercial applications, these leveraged contracts also provide an exciting playing field for the general public to speculate on the direction of prices within agricultural, energy, metals and financial markets. For people who enjoy predicting how economic trends impact different parts of our economy, the commodities markets provide the central arena to play out their projections.
The leveraged aspect of these financial vehicles demand close attention. Price fluctuations impact various types of trades in different ways. Over the long run, how traders manage risk often spells the difference between good, average and mediocre results. Risk management and discipline go hand in hand. The market, not your ego, should tell you when you are right or wrong, and what actions to take to pocket profits and limit losses.
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So if you would like to participate in these exciting markets, start asking your broker questions and then pick a few commodities. If you are a new trader, work with a broker for a while until you feel fully confident to completely steer your own ship. And once on your own, keep asking yourself questions to keep you within a disciplined framework. Where do I place stops? How much should I risk in my next trade? How long should I keep the position?
Experienced traders intimately know the challenges implicit in futures trading. The lessons learned from both winning and unprofitable trades can pay dividends in subsequent trading. Good traders do not hold onto positions beyond limits set before entering the market. As a new or a seasoned trader, do business with a brokerage firm that respects your level of experience and provides services to match your trading requirements. Stay focused and have fun!
A Trading Tale
Fred, an attorney from St. Louis, became interested in commodity trading after speaking with a co-worker at his law firm. His associate told him there is big money to be made in the commodities markets and that Fred could also triple his money in eight months just like he did in gold futures. “Just pick an undervalued or trending market and go long,” the associate advised.
Driving home that evening, Fred heard a radio report by an energy expert who expected oil futures to top $100 by the end of the year. Sure, the price of crude had already doubled in the past year, but the Mideast situation was heating up and meteorologists were predicting a colder-than-usual winter.
He funded a self-directed trading account with $10,000. Not only did he get a break on the commission costs; he thought why get input from a broker when he could always run trades by his associate. He placed his first trade, long 1 contract of January Crude Oil at the market, requiring $5000 margin. The order desk clerk asked if he would like to place a protective stop below the market. “No thanks, I watch the market every day,” Fred said. His order was filled at $71.50. With three weeks to go till Halloween, there was plenty of time for his prediction to come true, Fred figured.
His work demanded a lot, but he always found a few minutes to check the status of his trade. By the end of the week, crude settled at 73.25. Right on schedule, he thought. But by Halloween, the coldest one on record, it pulled back to 67.00 on news that OPEC was raising its production levels. His friend told him that nothing goes straight up and that the pullback would build strength for the next leg up. After a short rally to 68.75, two weeks later crude closed at 65.25.
Fred sent an email to his co-worker. “What’s going on?” he asked. “This was not supposed to happen.” He got a reply a few minutes later. “I would hang in there,” his associate wrote. “What else are you going to do? Don’t get out with a $6000 loss on the trade with a month left on the contract.”
The warmest Thanksgiving on record put most people in a happy mood. Not Fred. The following Monday, crude opened at 64.50. He called the order desk. “What should I do,?” he nervously asked the clerk. “I can’t really advise you sir,” the clerk responded. “You have a self-directed account.”
“Get me out,!” Fred screamed into the phone.
“OK, OK” the clerk said. You want to sell 1 contract of January Crude Oil at the market. Correct?”
“Yes, Yes. Sell the damn thing,” Fred said.
The next day, Fred closed his account and had his brokerage firm send him the remaining $3000 of his account balance. Despite his anger, he slept soundly for the first time in weeks.
What is to be learned by Fred’s trading experience? Several key things stand out. He came to the idea of trading upon hearing of the exceptional profits that a co-worker made in the commodities markets. Enamored of those gains, Fred figured he should be able to do the same. After learning how to place basic trades, he opened a self directed account to save on commissions. Rather than get input from an experienced broker, he relied on his associate as a sounding board. Instead of doing meaningful research, Fred developed his strategy from the predictions of a radio ad commentator.
Upon placing his order to buy 1 contract of January Crude Oil, he neglected to simultaneously enter a protective stop order under the market. This is an important rule of risk management for long positions. Also, the $5000 margin requirement for crude oil futures, fifty percent of his entire account balance, was an unacceptable risk to equity ratio.
Fred’s unrealistic expectations of one trade led him to get too strongly attached to the position. Though sometimes the futures markets act like a sprint, it is important to approach any trading plan as a marathon; a sequence of reasoned entries into and disciplined exits out of trades. A disciplined trading approach requires active risk management. This means sound research, patience, and the ability to act quickly when the situation merits.
*Note: The above story uses fictional characters and hypothetical situations that do not represent any real people or actual events. It is intended for educational purposes only.
For more information and to learn about futures and options, contact Steve Graubart at 866-239-1050; firstname.lastname@example.org.
There is a substantial risk of loss in trading futures and options