The Abcs of Commodity Futures

Commodity futures trading can be one of the most exciting and rewarding ways to invest your money. That said it can also be one of the riskiest. I don’t say this to imply that commodity futures are not a good, sound investment, because with the right research and risk control, commodity futures can be traded with less risk and far more profit than stocks.

Before we go into the nuts and bolts of trading futures, let’s get a little background on what makes commodity futures tic. First of all commodity prices are dictated by supply and demand. In each swing of the pendulum of commodity prices there is a change or perceived change in one side of the supply and demand equation. For example, if the Midwest Corn Belt receives too many days of rainfall in the spring and planting is seriously delayed, then the perceived result is less of a corn harvest. This would cause the price of corn futures to go up, as much as a prediction of a bumper harvest of corn would cause the prices to plummet.

A perceived danger to either side of the supply and demand equation can cause more of a price move than an actual event. For example, crude oil is a huge commodity; it is exported from the middle-east extensively. If there are political tensions between a couple of these oil producers then it could be perceived as a danger to the regular oil supply and thus effect prices.

One thing to also remember is how the effects on supply and demand affect the price of the commodity. If the supply of the commodity is going down then the price is going up and vice versa. If the demand for a commodity is going down then so is the price and the opposite is true on this also.

Before you begin to trade in the commodities market, you need to decide how much capital you will want to invest. Obviously if you have unlimited funds, this will not be a problem, but if you are like the majority of investors you will have to set limits. A small trading account would probably be between 5 and 10 thousand dollars. Don’t get me wrong when I say small, I still believe 5-10k is a lot of money, but in trading futures it is not.

Also before you begin the process of trading commodities, you will need to employ the services of a commodities broker. There are literally thousands of these all across the country and on the Internet. Brokers actually initiate the trades and charge a fee, whether it is flat rate or percentage, for the trade. Sometime the lowest fees are not always the best way to go, and if you do realize you have made a mistake in selecting a brokerage, don’t stay with them hoping for the best. This can and will cost you money unnecessarily.

Let’s review what we know so far:

1. Commodity trading can be very profitable.
2. Commodities are driven by supply and demand.
3. We are using risk capital.
4. We need a good broker.

Okay, we’ve selected our broker, opened our trading account so now were ready to trade commodity futures! Not so fast there! How will you decide what to trade? Which markets are moving and in which direction. Which markets are flat? These are all things you need to know before you put any money into a trade.

What a commodity has been doing in the recent past is usually a good indicator. What a certain commodity does at a certain time of the year is another indicator. These are called trends. The best way to research these tends is to find an on line charting service. Like the brokerages, there are a great many of these and quite a few are free. One that comes to mind is Plotting the daily progress of any commodity can give you a good grasp of what trend it is following. Looking at what a commodity is doing at a certain time of the year as compared to the last five or ten can be very useful when deciding to go long or short.

Whoa! Long, short, what!? These are terms used in commodity trading to determine what kind of contract you want to trade. In every commodity trade there has to be two things, a buyer and a seller. The buyer is purchasing the contract (or going long) and the seller is selling the same contract (or going short). One person will make money in this contract and the other will not. This is called speculation. The person who is buying believes the price will go up, the person who is selling believes the price will go down.

There are many ways to make money investing in commodity trading. Profits can be made when the price of the commodity is going up or down. The best way for a person to learn how to trade is to “paper” or pretend trade. This will let you know if your judgments or instincts are right most of the time. There are many more things you will learn over time, but for now these are the basics.

Whatever you do, do not let a broker bully you into making trades. He gets paid when you make a trade, but it is your money at risk. Make only the trades you want to make and when you want to make them.