Trading Commodity Futures: Beginner Tutorial

If you've ever seen the 1980's hit movie "Trading Places" you would have gotten a Hollywood style, brief introduction to the world of trading commodity futures. Commodities is the business of trading valuable necessities. The kind we use over and over again in one form or another, such as sugar, corn, wheat, soybeans, gold, silver, vegetable oils, cattle, oats and many more. The basic concept behind trading commodities is establishing the price of a product today (for example a bushel of wheat), which will then be delivered some time in the future. Thus, the name futures trading. This is a time-honored practice dating back to the early 19th century.

 

Businesses that produce commodities – as well as the businesses that use them as raw materials – need commodity futures markets to hedge against the risk of price changes. For example, a jewelry manufacturer preparing their winter catalog half a year in advance, would like to lock in the cost of the gold they'll use by purchasing gold in the futures market for delivery in six months. Likewise, a farmer worried in the spring that by harvest time corn prices might collapse, could sell corn for delivery in September. Of course, people that trade commodities aren't all farmers and jewelers. Most are just investors that are willing to speculate on the upward or downward movement of prices for these commodities.

The point is, we'll always need commodities one way or another. Wheat to make bread. Soybeans for oil and meal. Sugar for thousands of consumption products, and on and on. These are not fad items that will suddenly disappear. Sugar has been around for hundreds of years and will continue to be around for hundreds more. Same goes for corn, oats, and just about every other commodity. This means that prices for commodities will continually fluctuate responding to the laws of supply and demand.    

In essence, the commodity futures market is volatile, risky, but at the same time potentially very profitable. It is, in fact, the richest, most profitable and liquid market in the world. How liquid? ? In a single day there is more money invested in commodities exchanges than the total combined of the entire stock market! A true cash bonanza for those willing to take considerable risks. 
 

How Commodity Futures Markets Work

Commodities trade in large units called 'contracts'. For example, one contract of sugar which consists of 112,000 pounds, may be trading for 10.40 cents a pound on a particular day. As domestic and world events affect the law of supply and demand for sugar, the price for a pound of sugar will go up or down. In other words, prices for commodities, so closely tied to the laws of supply and demand, will constantly fluctuate over a short-term period.

This is one of the big advantages of trading commodities. Unlike the Stock Market, where the average return over the long run is about 10% to 15%, and where you usually hold on to your shares of stock for appreciation, in commodities your gains or losses are usually realized within a few days or weeks from the time you bought a contract. This means faster profit turnover (and potentially faster losses!). 

Now, back to our example, 112,000 pounds of sugar x 10.40 cents a pound equals $11,648. Does this mean that you would need $11,648 to own this contract? Absolutely not! In commodities you can control any contract with a very small margin amount. This is what we call leverage (a powerful wealth builder just as the type you're probably familiar with in real estate). It's another big reason why so many investors are constantly turning to futures trading. With relatively small deposits you control large contracts worth a lot of money.

If you feel a bit confused, don't worry. I'll explain in more detail in the next section.

 

Next: What is a Commodity