WHAT ARE COMMODITY MARKETS AND FUTURES CONTRACTS?

Within our trading systems, we focus primarily on commodity futures trading. In this chapter we shall describe what led us to choosing this kind of trading and what are the principles of commodity trading.

Commodities, as well as most of other underlying assets, are traded on the exchange. The basic types of exchange are:

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  • Financial Exchanges- Stock Exchange (stocks, bonds),
    • - Foreign Exchange,
    • - Financial Derivatives Exchange (e.g. options, futures)
  • Commodity Exchanges
    • - for trading commodities

So called FOREX is often incorrectly classified as an exchange, although this is in fact a global decentralised system for OTC (Over the Counter) trades with currency pairs.

During our practice, we have already met many traders. Many of them used to trade FOREX, which is the system for trading currency pairs such as the euro against the dollar, etc. They are mostly traded on certain software platforms which offer opening an account for ridiculous initial amount of money – e.g. several hundred dollars. However, the fact is, that we have personally never met anyone, who would profit from FOREX trading on long-term basis.

Another type of traders we met were stock traders. There are several of them we know that have succeeded in this kind of trading. However, the return of their investment was only a few percent (maximum te ns of percent per year). The problem of stock trading is, that there are strict rules for traders who want to do day trading. Should you trade via a U.S. brokers (just like we do - see further in this Handbook), it is necessary to open a trading account with a minimum deposit of 25 000 USD.

At the end, we have been the most influenced by traders who trade commodities in a form of futures. The turning point for us was a meeting with a futures trader who was able to increase the value of his trading capital by several hundred percent annually for several consecutive years. This was such a strong motivator that we have decided to fully focus on the world of futures. And today we can definitely say it was the right decision.

Let us first explain what in fact is futures trading

Futures trading is a kind of investing the basis of which is a speculation, that a price of a certain commodity (e.g. corn) will be higher or lower over a certain time in the future. Futures belong to a category of so called derivatives. In case of these trades, terms of buying or selling of the underlying asset get set at the moment of opening the trading position, whereas the trade itself gets settled under these terms in the future on the agreed date.

It is important to realise, that in case of futures it is possible to make profit not only on rise of commodity price , but also on its decline. Therein lies the difference between stock trading and futures trading. Let us first explain an example of stock trading. Shares of particular companies are traded on stock markets. It means it is possible to buy or sell securities of these companies in a form of shares. These shares certify their owners a real possession of a certain share on the company stock. A proportion of the share depends on the number of shares you own. We make profit in case that the market value of our shares increases because we can sell them on the stock exchange for a higher price than what we initially bought them for. In principle, traders mostly speculate on price increase on stock markets. Nonetheless, speculation on the price decline of shares is also possible. However, it is a more complicated process which we shall not describe in detail in this chapter.

In case of futures contracts it is possible to speculate both on growth and decline of futures contracts price. It is thanks to the fact, that physical delivery of a particular commodity is performed in the future. It is unlike in case of shares, where buy/sale and delivery happens at the same time, at the moment of execution of a trading order. Therefore the value of shares decreases by decline of their market price. Thus we shall primarily not speculate on the price decline. On the other hand, in case of futures, we can today (September 2013) open a trading position with a single futures contract of corn with physical delivery in December 2013 for price of 463 USD. After few days we shall decide to close the trading position, because the price of corn is now at 493 USD per contract. So, the clearing house of the commodity exchange will credit our account with the profit. The same way, we can speculate on the price decline, if we opened a trading position under the conditions that we shall deliver corn in December 2013 for the price of 463 USD. If the market price of corn declined to the value lower than 463 USD, it would be advantageous to close the trading position and to gain profit from the price difference.

In contrary to stock market, futures trading is based on trades with specific raw materials such as crude oil, corn, gold and other underlying assets as explained below. To simplify, we can say that futures trading is based on trades with commodities.

What is a commodity?

We are almost everywhere surrounded by commodities. Let’s mention at least few of them:

  • Corn - one of the main world crops. As a corn starch it is a part of almost every supermarket product. In addition, corn is the most widely used crop for feeding cattle and other animals.
  • Cotton - used not only in the textile industry
  • Gold - jewellery, decorative items, as well as essential components in electronics
  • Currency - currency pairs can be traded both on FOREX and in the form of futures
  • Crude oil - used virtually everywhere, even for production of toothpastes
  • and many other commodities which you will gradually get to know during your commodity markets studies.

The commodities are traded on daily basis by millions of investors, such as:

  • Banks - they keep increasing returns of their large capital,
  • Speculators - common traders who are not interested in taking over or delivering commodities. They only speculate on price movements (you may also become this kind of the trader in the future)
  • Funds - for example mutual or hedge funds, which manage capital of passive speculators who indirectly give their money to traders who trade on their clients behalf with the aim to increase the value of their investments.
  • Commodity producers - mining companies, farmers, growers, etc.
  • Commodity manufacturers - they need commodities for their business purposes, e.g. corn starch manufacturers buy corn, electronics manufacturers need silver to produce necessary components etc.

When talking about a group of so-called speculators, futures contracts trading is in fact an abstract and speculative investment. It is "abstract" because the trader (speculator) never wants to physically own a given commodity. And it is "speculative" because the trader aims to make money solely on rise or fall of price of the selected commodity. The speculator opens the futures position under the terms which get set at the position opening.

Summary:

In this chapter we introduced the principles of commodity markets. We explained what are the futures contracts and how they differ from stocks trading. And you learnt how it is possible to earn by commodity futures trading.

Team TradeandFinance.eu

(c) TradeandFinance.eu


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