In my trading I primarily focus on commodities that are traded through “futures contracts”. In this chapter I will explain what led me to this way of trading and what are principles of commodity trading.
Commodities, like most other underlying assets, are traded on exchanges. Basically, there are the following types of exchanges:
- foreign currency exchanges,
- financial derivatives exchanges (e.g. options or futures exchanges)
- securities exchanges (stocks, bonds)
- Commodity exchanges
- for trading commodities
FOREX is also often, yet incorrectly, classified among exchanges – Forex is an OTC system for trading currency pairs.
I have met many traders during my career. Many of them traded Forex, which is a system for trading currency pairs such as the euro against the dollar and so on. Forex traders mostly use software platforms that offer opening of several-hundred-dollar trading accounts for ridiculous fees. The fact is that I have never personally met anyone who gained long-term profits in Forex.
Another category of traders with whom I have met were traders oriented on stocks. Here I have met some successful individuals, yet appreciation of their invested capital reached only a few percent (few percents per year at most). The main problem which I see in the stock markets are the strict rules for traders who want to perform intraday trading. If you are trading through a US broker (like me – I work only with US brokers – as I will describe later in this handbook), the minimum deposit for opening an account is USD 25,000.
So far, I took the most from traders oriented on commodities, i.e. “futures”. The turning point for me was meeting with one trader who managed to increase the balance of his trading account by several hundred percent per year for several consecutive years. That was such a strong motivator for me that I decided to fully concentrate my attention on futures and I can say today that it was the right decision. On the other side it is very rare example – one of thousands I would say.
Let’s explain what futures trading actually is:
Futures trading is a type of investment based on speculation that in a specific moment in the future the price of a selected commodity will be higher or lower than today. Futures are classified among “derivatives” which are trades within which we agree on a transaction for the purchase or sale of an underlying asset, yet the transaction itself will take place in the future (on the contract date).
It is important to know that in the case of futures we can profit both on increases and decreases of commodity prices. That is the difference between futures and stock trading. First, here is an example of trading stocks. On the stock market you can trade shares of individual companies, i.e. buy or sell securities of individual companies in the form of stocks. Stocks are certificates confirming the real ownership of a certain share of the company. The size of the share depends on the number of stocks you own. If the market value of your stocks rises, you profit because you can sell these stocks on the stock exchange at a higher price compared to the purchase price. Therefore, stock traders in principle speculate on their stocks´ price increases. It is also possible to speculate on a decrease, but it is a complicated process which we are not going to describe in detail in this chapter. In futures contracts you can speculate either on a price increase or decrease thanks to the fact that the particular commodity will be physically delivered in the future (in the case of stocks the purchase/sale and the delivery are performed at the same time and therefore you always lose on a price decrease and you will not primarily speculate on it). For example, you can open a position with one corn futures contract today with the condition that this corn will be physically delivered to you in December 2013 for USD 463. After a few days you decide to close this position because the corn price reached USD 493 per contract and the futures exchange will credit the profit to your account. In the same way you can speculate on a price decrease – if you open a trading position with the conditions that you will physically deliver corn in December 2013 for USD 463 per contract. If the market price of corn decreases, it will be advantageous for you to close this position and take the profit from the price difference.
Compared to the stock market in futures you trade with particular commodities, such as oil, corn, gold, and other possible underlying assets. I will explain the principle later. Let´s start with the information that you trade with futures contract of a certain commodity.
What is a commodity?
Commodities are almost everywhere, here is the list of some of them:
- corn– one of the essential world crops, it is contained in almost every product in the supermarket (in the form of corn starch). Moreover, it is the most common fodder crop for cattle and other breeding animals.
- cotton– it is used in many more areas than just the textile industry
- gold– jewellery, decorative items, and also essential electronic components
- currency– currency pairs can be traded not only on Forex, but also through futures
- oil– oil is used virtually everywhere, even for the production of toothpaste
- and many other commodities with which you will get gradually acquainted during your studies of commodity markets.
These commodities are traded every day by millions of investors, among which are:
- banks– they strive for appreciation of their extensive capital
- speculators– ordinary traders who are not interested in the physical delivery of a commodity and who only speculate on price movements (in the future maybe you will become one of these traders)
- funds– for example mutual and other funds that manage capital entrusted to them by passive speculators. This means that the speculators indirectly give their money to someone who trades for them and tries to appreciate the entrusted capital,
- producersof commodities – mining companies, farmers, growers, and others.
- processorsof commodities – they need commodities for their business purposes, e.g. corn starch producers buy corn, electronics manufacturers buy silver for production of the necessary components, and so on.
If we speak about “speculators“, trading with futures contracts actually means abstract and speculative investments. It is abstract because the trader (speculator) does not want (and never will) to physically own the commodity. And it is speculative because the trader is trying to profit on the selected commodity´s price increases or decreases. The speculator opens trading position in a futures contract under conditions that are agreed at the moment of the opening the position.
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