I was at a party the other night when someone asked me what I do for a living. I responded that I was a commodities broker. This spurred them to ask, “What is exactly is that? I understand stocks but what are commodities?” This is a question that I have faced several times and I gave my usual response, “I work with traders and investors who wish to participate in the commodities markets to speculate on price fluctuation and market volatility.” This person pressed me on my response, so I went into some more detail explaining how I work with traders that use the futures and options markets as a way to speculate on the price movement of commodities.
I have this conversation with people more times than not. People are always looking for a way to increase their wealth through their understanding of world events. They are told to save for their future and the best way to do this is through investing in stocks and bonds. As they have some success with this, some seek to learn more about the markets and actually try to expand on their understanding of economic activity. Many look to the futures markets but get intimidated when they see the symbols, prices, and terminology. Further, they hear stories of extreme volatility in the futures market and believe that they can lose money quickly. At this point, any interest they have turns to apprehension as they don’t want to invest resources in something that they don’t understand.
However, learning a couple basic concepts can ease ones fears and possibly open a door to new opportunities in the futures markets. I often let people know that they already know more than they think. Through the knowledge they already acquired about the stock market, they already have a solid base toward understanding the futures markets. And while trading and investing can be extremely challenging, education and knowledge play a key role in success. But where does one start?
Step 1: Understand the similarities between stocks and commodity futures
Stocks and commodities are both assets that have value. Furthermore, both are tradable goods that have a value that is set in the market. A stock or a commodity futures price is set when a buyer and seller agree to trade. This asset (be it IBM, Google, gold, or corn) will either rise in price or trade lower depending on supply and demand fundamentals. Markets are fluid and constantly moving. Technical and fundamental analysis in the stock market is no different than in the futures markets. In most cases, dealing with commodity futures offers the trader more macroeconomic exposure to the market. For example, if a trader thinks that the stock market will go up, he may decide to purchase shares of General Electric or an S&P futures contract. By purchasing the S&P futures contracts the trader has a more direct exposure to the price swings of the overall stock markets than if he simply purchased one stock.
Step 2: Understand the differences between futures and stocks
There are some definite differences between trading stocks and trading futures. While many are intimidated by these differences, understanding a few principals can ease most of the tension. Below are some common differences that are easy to understand with a little research.
A company value is reflected in its stock price and commodity futures values are derived from the underlying price of the commodity: A stock is simply a partial ownership of a company. The value of the stock is reflected in its price. This is considered and investment because an investor is seeking to receive a return on his capital. A commodity future derives its value from the underlying commodity. A trader will either buy or sell the futures contract based on his expectation of the price of the commodity. For example, a trader that expects the price of gold to rise due to inflationary pressure would purchase a gold future. Whereas a stock is traded for dividend and market growth, one trades a commodity future on expected price action.
Delivery months: Each contract with futures has a delivery month, and the delivery months vary from contract to contract. Most traders use the “front month” as the month that they decide to trade. However, a trader can decide to trade any month listed on the exchange. The different months represent when the contract will be exchanged for the physical commodity. For example, a November 2011 soybean future will expire and be set for delivery on November 17th. Any trader holding this contract after this date will be subject to delivery of the commodity.
Pricing: Each contract has different pricing. For example, soybeans are traded in cents, gold is traded in 10 cent increments, and the ten year note is traded in points and 32nds. A simple and quick conversion is all that is needed to establish the price, cost, and value of each contract.
Any trades are educational examples only. They do not include commissions and fees.
Margin/leverage: When trading futures the trader is generally not paying the full price of the commodities value. The trader is putting up a portion of the total value of the contract (the minimum amount is called the margin requirement; this is set by the exchanges and is different for each contract). For example, if Dec 2011 corn is trading at $7.00, then the full value of the contract is $35,000. However, the margin required to trade this contract is roughly $2,400.00. The margin is set to guard against an adverse price move of one’s position in the futures contract. The trader is placing a smaller amount of the total value of the contract in order to “leverage” his exposure to the commodity future. Many traders enter the market looking only at the margin when establishing a position. While this is essential to trading, understanding the total value of the contract is equally important. By not properly using margin and leverage, a trader can easily encounter issues with his account and be subject to a margin call. For example, a trader who has $13,500 in his account may decide to purchase two gold futures. The margin for gold is $6,750 and the maintenance margin is $5,000. If gold declines in price over $17.50 a contract, the traders account will be subject to a margin call. This means that either more money must be added to the account or the position will be liquidated.
Summary
While it’s true that there are definitely some differences between stocks and commodity futures, understanding each takes studying and research. To take advantage of the markets, one needs a good idea, sufficient capital, proper risk management, and solid execution. Although commodity futures are not right for everyone and every situation, but by understanding the basics of the market a trader or investor opens the door to new opportunities. And in the end, that’s all anyone can really ask for.
