Commodity Trading FAQ

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Stocks and bonds aren’t the sort of thing the novice investor typically thinks of as a commodity. Even less do they view a statistical measurement of changes in their prices as similar to gold, wheat or oil. Yet, because stocks and bonds (and the indexes that measure price changes) trade in the form of futures and options contracts, they can be traded in the same way as other commodities.

While oil remains the most traded physical commodity, the financial futures market today is the largest for all contracts traded. One of the most popular is the contract for the Standard and Poor’s 500 Index, the S&P 500.

As the, so to speak, gold standard of indexes the S&P gives traders a broad view of the stock market as a whole. The companies contained in the S&P 500 represent 80% of the entire market capitalization - the top 40 stocks in the S&P 500 represent 50% of its total.

That means traders can be confident that there will be no liquidity problems, as sometimes happens with some other commodities.

It also means risk is easier to assess. The tools available to measure and predict the S&P 500 are more reliable, since predicting stock prices is much easier than that of commodities. Easier, but definitely not easy. Just as one example, the stocks in the S&P 500 have reliably offered the highest return over a 30 year period of any investment, around 12% depending on the range selected.

Stock prices can definitely be volatile, and large single-day price drops have happened several times. But indexes typically, by design, move less far and less rapidly than other prices. The idea of using a broad based index is precisely to smooth out the bumps of individual stocks, in order to assess the direction of the market as a whole.

Yet, along with reduced risk and better predictability, traders still enjoy the other advantages attendant on using futures and options as trading vehicles. Margin percentages are in the 5-7% range, so high leverage is still available, as it is with other commodities futures and options contracts.

Commodities trading is often very short-term oriented, with day trading the norm. Yet with index trading, investors can take advantage of those sharp swings, yet still take a long-term horizon view, as they would with ordinary stock investing.

For example, one common trading strategy is the ‘rollover’. This technique allows traders to take a long position on a futures contract, then - as expiration nears - transfer the position to another contract with an expiration date farther out into the future.

This ’spread’ strategy makes it possible to take advantage of price differentials and low commissions, while controlling the liquidation date. It’s executed when traders predict that prices will soon move in the preferred direction, where ’soon’ is just beyond the expiration date.

S&P Index futures are traded on the CME (Chicago Mercantile Exchange), and there’s even an S&P 500 ‘E-mini’ contract available, which carries a smaller commitment - one-fifth the standard contract. The trade unit is $50 time the S&P 500 Index. The trade unit for the standard contract is $250 times the S&P 500. In addition, since it trades all electronically, with no open outcry or pit trading, trading hours are almost around the clock.

For current prices and contract specifics, see the CME website at http://www.cme.com/.

Suppose you’ve been reading the newspaper lately and seen the substantial rise in inflation over the last two years. You bet, along with many others, that this trend is likely to continue for the next two years. You decide to hedge your portfolio, and possibly pick up some profits, by investing in gold.

Unfortunately, you don’t have $58,000 to purchase 100 Troy ounces of gold at the current market price of $580. Instead you do what most speculators do, you buy a gold futures contract. Now instead of having to come up with $58,000 you only have to invest an initial amount of $2,900, 5% of the total.

That 5% is known as the (initial) margin. The exact percentages are set by the exchanges and brokerage firms on a daily basis, per individual commodities futures contracts. Exchanges monitor prices, volatility and many other factors to determine acceptable levels of risk and then set the margins accordingly. Minimums are set by the exchange, but brokerages will sometimes have slightly higher requirements.

Now suppose the price of gold rises by $5 before the expiration of the contract. Excellent. You’ve made $5 per ounce x 100 ounces = $500 (excluding commissions, around $20). If you had purchased the gold outright you would have made the exact same amount of profit. But look at the difference between outright purchase and a futures contract in percentage terms.

$500/$58000 x 100% = 0.86%, slightly less than 1%. On the other hand, $500/$2900 x 100% = 17.2%. That difference is the effect of something known as leverage. You invested only 5% of the total purchase price, but you still get 100% (ignoring commission) of the profits, not 5% of the profits.

But with the possibilty of reward comes the risk of loss. If the price had decreased $5 and never rose again before the contract expired, the result would have been a $500 loss instead. In order to protect themselves against the possibility that you won’t be able to cover the amount at expiration, brokers may issue something known as a ‘margin call’.

All potential profits and losses are calculated and settled on a daily basis. If the price drops below the minimum set by the broker (based on the exchange minimum), brokers will require their clients to deposit additional funds to bring the account back up to the level of the initial amount.

Here’s the kicker. They may or may not give you adequate notice and time to actually do that. Depending on the level of price volatility, the amount involved, and your relationship with them, brokers can (and sometimes do) liquidate your position without waiting for you.

Under normal circumstances, most brokers will give you notice and reasonable time to meet this ‘maintenance margin’, the amount required to bring your account up to the required level. But it’s the trader’s responsibility to monitor his or her positions and know the guidelines.

Beyond bringing the account up to the previous level, it’s possible you may have to come up with an even larger amount. Exchanges and/or brokers can and do raise (or lower) the minimums depending on current market conditions.

Futures trading, particularly in the fast-paced, high risk world of commodities, isn’t for everyone. A high tolerance for risk and the ability to input additional funds is necessary, along with the ability to withstand the losses.

Most commodities trades are executed in the form of futures contracts. A specified percentage of the asset price is paid and a buyer accepts the obligation to deliver (or take delivery of) a set quantity of the good at a future date. Hence the name.

Why do futures offer any advantage over trading the commodity directly? They’re riskier, since they expire within a certain amount of time, and their values are more complicated to assess. The asset price is difficult to predict, and the price of a futures contract in the future is even more so. Contracts are bought and sold in a way similar to stocks or options.

As derivatives they have no inherent worth. A derivative is a financial instrument that ‘derives’ its value from some underlying asset. What do commodities futures traders know that some investors have yet to learn? One thing they know is the value of leverage.

Imagine a teeter-totter in a children’s playground. A small child can lift an adult into the air, provided the pivot point under the horizontal plank is placed in the right spot. That force ‘multiplier effect’ has an analogy in financial markets.

For somewhere in the neighborhood of 5% of the price of the commodity, an investor can control - even though he doesn’t own - 100% of a quantity of the good. That’s leverage. The 5% figure is known as ‘the margin’. The specific number varies depending on recent price volatility, legal regulations and several other factors.

Suppose gold is trading at $580 per Troy ounce on the CBOT (Chicago Board of Trade). 5% of $580 equals $29. Therefore a trader purchasing a futures contract for, say, 100 troy ounces, can control $58,000 worth of gold for only $2,900. The broker, in effect, loans the trader the rest of the money. Not a bad deal considering that commissions are in the range of $15-$40 for a ‘full turn’, i.e. a pair of trades to buy and sell.

Now imagine the price rises to $585 before the expiration date of the contract. The net profit is: $585 - $580 = $5 per ounce. $5 per ounce x 100 ounces = $500. The percentage of profit is: $500/$2900 x 100% = 17.2%. Considering the modest amount invested, a very decent return. And such price swings for gold happen almost daily. It goes without saying that the price can just as easily, and even more quickly, fall.

Futures have other advantages over the spot market. Suppose you actually had enough capital to purchase 100 troy ounces of gold. You now have transportation, storage and security problems.

If the commodity in question were, say, oil your problems intensify. Even if you could afford to purchase, transport and store 1,000 barrels of oil (the standard minimum contract amount, equal to 42,000 gallons), very few dealers are going to take it off your hands. They only do business with professionals who deal in very large quantities.

So unless you bought it to use rather than trade, you are going to find it difficult to sell again. If you could sell it, you again have a transportation problem and expense.

Small wonder that almost no traders ever see the actual commodity. Nevertheless, don’t forget that, unlike options, futures contracts carry the obligation to deliver (or take delivery of) a good by a certain date. Rarely are the contracts for longer than a year.

In practice, of course, the contract is sold on or before expiration at either a profit or loss (or breakeven). The actual goods are ultimately transferred to an end consumer (jewelers, refineries, bread making companies, etc) by a specialty broker.

Take advantage of futures and the leverage they provide.

Let’s examine a highly simplified commodities future contract trade.

Suppose a trader buys a contract to purchase oil trading on NYMEX (The New York Mercantile Exchange) at $70 per barrel for WTI with an expiration date of August 6th. (Oil comes, obviously, from a variety of major sources, including the North Sea near England, Alaska, Saudi Arabia, West Texas, etc. The locations often lend their names to the different sub-types of commodity and generally have different prices).

Note a number of things about this contract, called a future.

It names a specific commodity. It isn’t a contract for North Sea Brent, it’s for WTI (West Texas Intermediate) Crude. Though oil as a whole is a commodity with similar properties, the actual material recovered varies from place to place. There are as many types and names as there are for cigars.

Because of differences in cost of production, refining and shipping costs, inherent composition and many other factors not least of which is expected demand, prices can and do vary.

It has a specified price: $70 per barrel. A portion of that money, called the margin, is to be paid today. The required margin amount changes depending on a number of factors, such as how volatile prices have been in the recent past. But somewhere around 5% is typical.

Each contract specifies a set amount, typically 1,000 U.S. barrels (42,000 gallons, equivalent to roughly 168,000 liters). At 5% of $70 per barrel, a contract for a 1,000 barrels requires a minimum investment of $3.50 x 1,000 = $3,500.

For an investment of $3,500 the speculator is controlling $70,000 worth of oil. That’s known as leverage.

The contract has an expiration date and an associated obligation for delivery. On or before August 6th the contract holder has to deliver 1,000 barrels of West Texas Intermediate Crude with specified characteristics. Exchanges determine such things as minimum acceptable levels of sulfur content, for example.

The vast majority of traders are never going to see a drop of that oil and don’t have any real expectation of delivering it. They don’t have it to deliver. They are trading contracts for goods, not the goods themselves. The final contract is ultimately handled by a specialist broker who ensures delivery of the actual product to some ‘consumer’ like an oil refinery.

The important point for the average trader is simply that they have to do something by a given date. That has interesting consequences, such as the change in price for the contract itself as the expiration date nears.

Unlike an options contract, a futures contract carries not only the right to buy or sell something at a given price by a specified date, but the obligation to do so.

If the spot price (the price of a barrel of oil at a given time, in a specific market) changes, the trading price for the contract will change as well. How it changes, and by how much, we have to leave for later. But suppose the price for WTI rises to $75 per barrel before expiration.

How much profit, in percentage terms has the trader made?

$75 - $70 = $5 per barrel. $5 per barrel x 1,000 barrels = $5,000. $5,000 - $3,500 = $1,500 (excluding commissions). $1,500 / $3,500 x 100% = 42.86%.

A very healthy return and, in today’s oil market, not at all unrealistic. Of course, anyone considering commodities trading should be fully alert to the possibility - even in today’s market - that the price of oil (or any other commodity) can and does fall as well as rise.

Why aren’t paintings commodities? Because each one is unique. Commodities are uniform and one individual or portion serves the same purpose as any other. An ounce of gold, a barrel of oil, a bushel of wheat. In every case, one is pretty much like another. It makes little difference to most of those buying it whether they receive this ounce of gold or that one.

Observe there are some differences. Because of shipping costs, differences in composition, and so forth, some oil does sell for a different price than that from another source. Texas crude and North Sea oil are close enough for many purposes, but they trade on different markets and have different prices.

Commodities can be traded on either spot markets, or in the form of futures.

Spot markets are those in which the commodity is traded immediately in exchange for cash or some other good. You go to the local jewelry store and buy an ounce of gold. That’s a spot trade. You give the jeweler several hundred dollars in cash, he gives you an ounce of gold, usually in the form of a coin, ‘on the spot’.

Other traders exchange commodities on spot markets in much greater quantities - thousands or millions of ounces of gold or barrels of oil. At some time the actual good is delivered. After all, at some point, someone has to use the good or it’s, so to speak, no good.

In the form of futures (or options), what is traded is not the good itself, but a contract to buy or sell the commodity for a certain price by a stated date in the future. Hence the name.

Most commodities trading is done in the form of futures or options and it’s that scenario that gives rise to most of the huge potential for profit and loss. It also gives rise to all the interesting aspects of trading, since it inherently involves predictions of the future and hence uncertainty and risk.

Commodities trading has been around for centuries, but the modern markets arose in the late 18th century when farming began to be modernized. Though the pace of trade and many of the detailed mechanisms has changed, the basics are still the same.

Growing wheat, for example, took several months then from planting to harvest to delivery. It still takes several months. A farmer might plant wheat in April and discover in June that the price someone is willing to pay for delivery in August has dipped over the past month.

For example, suppose on May 1st wheat to be delivered September 1st is selling for $4.00 per bushel. By June 1st, it has fallen to $3.80. The farmer may believe the price will continue to fall. He offers a contract on his wheat to be delivered September 1st for $3.80 per bushel, locking in a price today at the current market level. In exchange, he accepts a legal obligation to deliver the wheat on or before September 1st.

Fortunately for the farmer and others, some believe the price will in fact not fall but instead will rise by September 1st to $4.20 per bushel.

That kind of prediction is typically based on a very complicated analysis of current conditions, such as the total amount of acreage under plant, soil moisture levels, weather predictions for the coming months, political events and dozens of other variables.

No one knows the future price with certainty, that’s why it’s called speculation.

Come September 1st the farmer delivers his wheat and is paid $3.80 per bushel. If the price turns out then to be $4.20 per bushel, the speculator makes a healthy profit. If the price is, say $3.50 per bushel, the speculator has lost money.

That’s commodities trading in a nutshell, or rather in a basket.