Advanced Methods of Trading Commodities

The subject of style and advanced methods of trading commodities is too complex to cover in depth with all its possibilities. The primary objective of this tutorial is to introduce you to the basics of the marketplace; the nuts and bolts of how commodities are traded. But I would also like to briefly extend our discussion into other areas and strategies used in commodities trading.
 

Spreads

In its simplest form, spreads involve buying one futures contract, and at the same time selling another futures contracts. You're hoping to profit from the expected change in relationship between the purchase price of one and the selling price of the other.    

For example, let's say July corn is currently trading at $3.00 a bushel and September corn is currently trading at $3.05 a bushel. Your assessment of the market is such, that you believe the price difference between these two contracts will widen beyond 5 cents. Therefore, you sell July corn futures contract and buy September corn futures contract. Assume you were right, and the July corn futures price rose to $3.50 while the September corn rose to $3.75, a difference of 15 cents. By liquidating both contracts at the same time, you realize a net gain of 10 cents a bushel from the spread. In other words, a $500 profit. However, if instead of widening, the price would have narrowed by 10 cents a bushel, you would have incurred a loss of $500.

A true spread opportunity exists when there is an interrelationship between the commodities being spread. If you can reach an understanding of the fundamental forces influencing the spread of two contracts, you stand to benefit. For instance, several years back, there was a situation where Italy had a very bad wheat crop. Thus, the prices of durum wheat, which is ideal for pasta, ran through the ceiling in Italy. Durum wheat is grown in our northern states and traded in the Minneapolis Exchange. On the other hand, the wheat traded in the Kansas City exchange is hard red, with high protein content and a lot of gluten, making it ideal for bread. Both of these contracts usually trade within a few cents difference. However, given the fundamental forces of supply and demand at that time, the price gap between these two contracts widened, with Minneapolis wheat trading at a premium.

 

Options

Options on futures contracts are a relatively new type of investment in commodities. Their greatest attraction is that they offer an option buyer the potential for substantial profits while limiting his risk to the up-front cost of the option (known as the premium), plus commissions and other transaction costs.

However, despite the pre-defined risks for the buyer, options is not an appropriate investment for everyone. The fact that you can lose your entire investment in a short period hardly qualifies them as a low risk investment.  
 

Buying Call Options

The buyer of a call option acquires the right, but not the obligation, to purchase (go long) a particular futures contract at a specified price at any time during the life of the option. Each option specifies the futures contract which may be purchased (known as the underlying futures contract) and the price at which it can be purchased (known as the exercise or strike price).

A reason to buy a call option is to profit from an anticipated increase in the underlying futures price. A call option buyer will gain if, upon exercise, the underlying futures price is above the option exercise price by more than the premium. Or a profit can be realized if, prior to expiration, the option rights can be sold for more than they cost.   
    
For example, you expect lower interest rates to result in higher bond prices. Therefore, you buy a June T-bond 90 call. Assume you pay a premium of $2,000. If, at the expiration of the option in May the June T-bond futures price is 96, you would realize a gain of 6 (that's $6,000), by exercising or selling the option. Your net profit in this case is $4,000.

Although an option buyer cannot lose more than the premium paid for the option, he can lose the entire amount of the premium. In this case, $2,000. This would happen if the option held until expiration is not worthwhile to exercise.
    

Buying Put Options

The buyer of a put option acquires the right to sell (go short) a particular futures contract at a specified price. Put options can be purchased to profit from a price decrease. Just as with call options, the most that a buyer of a put option could lose if he is wrong about the direction or timing of the price change, is the option premium plus transaction costs.

For example, expecting a decline in the price of gold, you pay a premium of $1,000 to purchase an October 400 gold put option. The option gives you the right to sell a 100 ounce gold futures contract for $400 an ounce. The $1,000 is the money you put at risk. Assume that, at expiration, the October futures price has declined to $370 an ounce. You can now exercise your option giving you the right to sell at $400 for a gain of $30 an ounce. On 100 ounces, that's $3,000. Minus the $1,000 paid for the premium on the option, your net profit comes to $2,000.


Selling Options

Options are sold by other market participants, known as option writers. Their goal is to earn the premium paid by the option buyer. In other words, if the option expires without being exercised, the writer retains the full amount of the premium. Conversely, if the option buyer exercises the option, the writer must pay the difference between the market value and the exercise price. Though option writing carries a greater reward potential, it can be highly risky, with possibilities of unlimited losses.

The reader should be aware that this is a simplistic discussion of options. Options trading, in fact, has its own vocabulary and arithmetic. Therefore, to trade options properly one must understand them in detail. 
 

Other Theories

Elliot Wave Theory

The Elliot Wave theory is based on the premise that all natural phenomena are cyclical, and market behavior trends and patterns follow this cycle. Prices unfold in "five waves" of crowd psychology when moving in the direction of a primary trend. Then they move against the trend in "three waves." The wave patterns reflect life's starts, false starts, stops and reversals. By identifying the exact position of the current price activity within the wave patterns the trader should anticipate the market's next move. Once you're synchronized with the wave patterns, you can ride the economic waves of the markets. While the Elliot Wave has a group of devoted followers, it doesn't have much credence with professional statisticians.

 

Gann Numbers

In his 1942 book, How to Make Profits Trading Commodities, W.D. Gann advanced his ideas of precise mathematical and geometric predictive patterns that govern, among other things, the commodity markets. He believed these patterns could be uncovered and exploited in order to profit from the markets. An important basis for his trading system are the Fibonacci Numbers.


Fibonacci Numbers

Although reputedly designed by Fibonacci, a 13th century Italian mathematician, as a study exercise for his students, the Fibonacci numerical progression has received a great deal of attention from many technical analysts. The numerical series is created by starting with 1, with each succeeding number being the sum of the preceding two numbers: 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, etc. Using these numbers in various calculations as divisors or multipliers generates a ratio of 1.618 or 0.618.

This was called the golden ratio by the ancients because it appears widely in nature (branching of trees, flowers, sea shells, etc.) and is appealing to the eye. It was used in structures such as the Egyptian pyramids and the Sistine Chapel. As a result, technical analysts reason that if the golden ratio exists in nature, is used by mankind, and is pleasing in formation, it should appear in price charts as well. When it does, they give special attention to price advances or retracements that reflect the golden ratio.

Frankly, we're not quite sure what Fibonacci would have thought of all this, since his number progression was originally constructed from observations on the incestuous copulation of rabbits!

I've covered but a few of the many trading approaches in the world of commodity futures trading. The purpose of this tutorial was to give you, the beginner, a better understanding of the basics in commodities and how it all fits together. I presented you with the potential rewards, risks and possibilities in this profitable world of commodities.

    But the learning process is one that never ends. As you can imagine, it’s an ongoing process and you should continue to educate yourself every opportunity you can. Whether your interest lies in trading commodities by using one of the many technical analysis tools, or by trading by fundamentals, or by trading options, you need to continue adding to your knowledge base. Remember, your mind is like a parachute, it only works when it’s open.  Every new piece of information you take in, is like adding another building block that will reinforce your structure of knowledge. Ultimately, knowledge is what differentiates the winning trader from a losing one.
   

Next: Glossary of Terms