Published On: Sun, Jan 19th, 2014

Trading Commodities

One of the largest speculative markets is the commodity market. This includes the “futures” market, although you can have futures contracts on other things such as stocks nowadays.

Commodities cover a wide range of goods. They include agricultural products, such as soybeans, wheat, corn, coffee, and sugar; livestock and meat which includes cattle and pork bellies; energy products such as natural gas and crude oil; and metals, including gold, silver, platinum and copper.

The commodity market is traded in a couple of different ways. The “spot” market is for people who actually want to buy the commodity today, such as manufacturers and suppliers. Futures contracts are used by manufacturers to ensure supply of raw materials at a price they can budget and afford, and used by producers to guarantee they’ll get a certain return on their goods.

This is the reason that futures contracts started. Imagine you are a farmer, trying to decide what crops to plant. If you can take out a contract to supply corn or wheat six months in the future, and know exactly how much you’ll get for either, you can work out which one to plant to get the best result. There are two sides to this – on the one hand, the farmer may not get the maximum he would have if he had waited and sold it on the spot market. On the other hand, if there is a bumper crop, or if everybody is growing the same thing, the spot price might be lower than the price agreed on the futures contract. Either way, the farmer is not bothered if he has a futures contract on which he will get a reasonable profit. It makes his financial outlook more predictable.

This also works on energy contracts. The classic case is for airlines to purchase futures contracts for delivery of airline fuel. They cannot raise and lower their fares every month to suit the price of aviation fuel, but with futures contracts they know in advance how much they will spend on this major cost of operation.

Because of their nature, futures contracts are also used a lot by speculators who may make or lose fortunes with them. You do not have to come up with the price of the goods in advance, simply the price of the contract which can vary depending on the market outlook. This means that your money can be greatly multiplied by dealing in futures contracts, though once again you can profit or lose depending on your choices.

The commodity market is standardised and regulated. You do not have to find your own buyer or seller when you want a contract, but simply go to the appropriate marketplace and open a trade. The quality and quantity of goods is defined and guaranteed, and each contract is for a standard amount, such as 5000 bushels of corn or 1000 barrels of Brent Crude oil.

The goods are due on set dates in the future, so the whole process is very organised. Much of the trading never finishes with the delivery of the goods, simply because it is for speculation. In fact, if you trade on the futures market you would have to be doing something seriously wrong to find yourself with the standard lot of 40,000 pounds of bacon (lean hogs) on your doorstep!

Before standardisation, manufacturers and producers might have agreed “forward contracts” between themselves. These were the precursor to futures contracts, and are similar in intent, with the agreement to supply certain goods at a certain price on a date in the future, but they lack the standardisation that allows futures to be freely traded. The contracts were very specific, and the buyer and seller knew who the other one was.

Forward contracts could be specifically tailored to the buyer’s needs and the seller’s abilities. They didn’t have to be for Brent crude, if the buyer wanted and the seller had access to Heavy Louisiana Sweet oil. The contract could simply be written for this type of oil and the quantity needed. Forward contracts are very likely to be taken through to completion, rather than being traded away. Forward contracts are still used, but usually for specific cases.

Futures markets offer big rewards for those who can comfortably trade them. The quantities involved are huge by normal standards, and likewise the contract price for delivery is very high. To become involved in the contract, speculating on buying or selling a commodity, is much cheaper, so you have a large multiplying factor in your trade.

There are certain global trends that you can follow with futures. For instance, with the emerging world becoming more industrialised it is competing for goods such as copper and other industrial metals, and this will push the price higher over time. Similarly, many people in India desire to buy gold, and take great pride in wearing it in jewellery. These factors will influence prices, but possibly only over the longer term.

For active speculation of futures, the more exciting commodities are the agricultural and energy ones. At the mercy of weather and disease, crops can fail or be abundant, and either case will play into the pricing. With the lack of predictability of the weather, these contracts may make you nervous. There is an element of chance that no one can control.

With energy contracts. we are always seeing the way that oil prices go up and down. They can be influenced politically, by the Saudi’s opening or closing a tap, for example, as well as a severe winter raising demand for heating oil. It is because of their volatility that they are traded by many speculators, and if you become involved in this market you should be aware that many of the traders on the opposite side of contracts you take are extremely experienced and specialise in the field.

By the way, you may be wondering how the farmer works out how many futures contracts he can sell. Obviously, he has to balance the security of having sufficient futures contracts and not chance selling too much excess on the spot market at a possible lower price against the possibility that the harvest will be disappointing and he will not have enough of the crop to satisfy the contracts he has taken out. That is something that comes with experience, but you should note that the farmer can himself buy some future contracts for how much he thinks the shortfall could be, paying a little for the assurance that he won’t be stuck. If he finds he doesn’t need the contracts, he could always sell them on at whatever the market rate is.

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About the Author

- Robert is a private trader with over 15 years experience trading the financial markets.

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