In previous chapters we focused on market participants who contribute to creation of commodity prices. As we already know commodity markets are traded on commodity exchanges. Remember that as traders you have to concentrate on highly liquid markets. Yet before we introduce the main commodity exchanges and the potentially attractive markets, we must clarify some basic concepts – Commodity Exchange, Pit and Electronic markets – and briefly explain why they are important.
Commodity Exchange is a highly organised and regulated market where a variety of underlying assets can be bought and sold (mostly commodities) through futures contracts. The exchange allows meetings of buyers and sellers and conclusions of bilateral agreements. If such an agreement is concluded and the buyer and the seller agree on a price, their orders are “paired“. The final price of traded commodities is always a result of the current supply (Bid) and demand (Ask). Most of you probably have probably come into contact with the environment of an exchange, most likely in some American movie. Thus you may think that an exchange is a place with a lot of guys standing with papers in their hands, shouting at each other, and closely watching electronic boards with constantly changing numbers showing the current state of supply and demand.
The exchange environment may be a great unknown for you if you do not understand the principle on which it is based and how the exchange prices are actually formed. Neither the media will help you in understanding this phenomenon as they only spout information about the ratio of the euro against the Czech crown and the dollar, values of stocks of Facebook, Apple, and other corporations, and then about those damn meaningless indices – S&P 500, Czech PX, German DAX, and so on. Who should sort all this? Before I started to trade on the exchange I was also confused. I asked myself questions like: “What makes the prices in charts move? What is the purpose of this entire exchange circus? What are those derivatives? How is it possible that the development of an artificial index, something as abstract as e. g. “S&P 500″, can have such a major impact on economic development?” And then there was the most important question: “How do people actually make money here?” Be sure that as a prospective trader you do not necessarily know the answer to any of these questions. Well, except the last one. I believe that after reading this handbook you will be able to answer this crucial question. The rest will be up to your hard work and effort.
In order to understand the current exchange environment, the first thing we have to explain is the difference between the “pit” and “electronic” trading.
Pit vs. electronic trading
Pit and electronic trading are two main ways of trading at today´s exchanges. Pit trading is performed on a “Trading Floor” which is a place in the exchange´s building (also called “Pit”). It is a place where people physically conclude individual trades. In English terminology these people are called “Floor Traders”. A typical Floor Trader is a big man with a strong resonant voice. In the trading jargon their communication (in the form of gesticulation and shouting all at the same time) is called the Open Outcry. Pit trading was the predominant type of trading until the end of the 90s of the 20th century when it was superseded by electronic trading. However, even today some futures contracts of certain commodities are traded on pits. Yet it is only a fraction of the total volume of all traded markets and contracts.
Electronic trading has been gradually gaining in popularity since the beginning of the 21st century and today it is without doubt the dominant method of trading in commodity, stock, and foreign exchange markets. This type of trading is entirely performed outside the trading floor – the whole process takes place on exchange servers. Electronic trading (or online trading) in stocks or commodities has much more advantages than the traditional pit trading. Here are the fundamental ones:
- You do not need to be physically present at the exchange (unlike pit trading). Thanks to the massive technological boom and development of the Internet in recent years and its availability across the world trading became available actually anywhere and almost to anyone. Thus the markets became much more interesting also for small traders and trading on major exchanges worldwide ceased to be a privilege of affluent elites.
- Faster execution of entry and exit orders. In other words, you have a much higher chance that you will enter and exit your trading positions at the intended prices. Possibility to trade many different markets at once. A pit trader, on the contrary, can usually trade only one pit market.
- Much lower broker fees (Commissions).