Beginners Guide to Commodities Trading

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In the financial world, the term commodities refers mainly to bulk goods (rather than finished products) that are traded using futures contracts. Most commodities trading arises when businesses use futures contracts to safeguard other market positions. For example, a food producer will buy futures for wheat to protect against the possibility that a poor harvest will drive up the cost of raw materials. Commodity speculators also buy and sell futures contracts in hopes of reaping large profits from changes in commodity prices.

Structure

  • The futures contracts used to trade commodities are agreements that one party will deliver a specified quantity of a good (for example, 5,000 bushels of wheat) to another party at a future time but at the current market price. Traders can purchase "call" contracts to buy or "put" contracts to sell the commodity.

    Commodities trading started in the 19th century as part of the rapid expansion of American agriculture. Farmers would sign contracts with buyers for the delivery of their next crop at an agreed-on price. With a guaranteed price to show the bank, the farmer could then borrow money to raise the crop. Food manufacturers buying agricultural products could conduct their businesses with the assurance of predictable costs for raw materials.

    Today a wide variety of products are traded on commodities markets like the Chicago Board of Trade. Agricultural commodities include crops, livestock and wood. Minerals are another category and include metals, petroleum and chemicals. The use of futures has expanded so that contracts are traded for currency, T-bills and other securities.

Trading Commodity Futures

  • Commodity trading transactions are made on margin. This means the trader puts up a small portion of the cost of the contract (5 to 10 percent is typical) and borrows the rest from his broker. A change of just 10 percent in the price means you can double your money.

    However, this feature makes commodities trading risky. If the price goes the other way, a 10 percent change means you lose all the money you invested. In theory you can lose even more except your broker will issue a margin call first. You must then put up more money or the transaction will be closed out.

How Trades Work

  • Let's say you buy a call contract for 100 ounces of gold at $800 per oz. The contract is worth $80,000, but you only put up $8,000 (10 percent). If the price of gold goes up to $880 per oz., the contract is now worth $88,000. You sell and make $8,000 profit (minus broker's fees and commissions).

    Suppose instead you bought a put contract for the gold at $800 per oz. This guarantees you can sell the gold at $800 per oz. If the price goes down to $720 per oz. you can buy the gold at that price, use it to complete the contract and be paid $800 per oz. Your profit is $80 per oz. or $8,000. In practice, contracts are normally "settled for cash," so you don't actually have to go through the process of buying and reselling the gold or other commodity.

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