Commodities Trading

Introduction to Commodities – Part 1

What are commodities, and how are they different from other investments? Commodities are uniform portions of a like product, and may include things like gold, oil, wheat or livestock.

Each portion is exactly alike, so commodity trading does not specify which portion you are buying – they are all the same. The difference between commodities and say, a piece of fine art is that each piece of art is unique and different from the next.

Within these categories of commodities, there may be some differences, however. For example, different levels of purity and shipping costs will cause variances between Texas crude or North Sea oil; these different types of oil investments are actually traded on different markets.

When trading commodities and investing in this type of asset, you’ll have the choice between trading on ‘spot markets’ or in ‘futures’.

These ‘spot markets’ are areas or locations where you may immediately trade your commodity in exchange for cash or some other item of value. Buying physical gold from a retailer or wholesaler is a ‘spot trade’. You exchange cash for a certain amount of gold ‘on the spot’, thus the name ‘spot markets’.

Some investors may choose to trade commodities on spot markets in large quantities of thousands or millions of units. This would be the case for a large wholesaler needing thousands of ounces of gold to craft new jewelry pieces.

‘Futures’, also called ‘options’, do not trade the actual and physical product, but investors purchase a contract to purchase or sell units of a commodity at a specified price on a future date.

The majority of commodity trading is conducted in the form of these futures and options; this form of paper trading lends way to the possibility of huge profits and losses in the daily markets, attracting many commodity investors. Much like other forms of paper trades and investing, trading in commodities requires the investor to predict the future price movement of these units of goods.

Futures trading was modernized in the late 18th century with the modernization of farming practices. Over the past several centuries, this process of investing has been largely changed, but the underlying principals remain the same.

When considering corn, a common crop produced by farmers, this commodity requires several months from planting to maturation and harvest. For example, corn to be delivered in September may be priced at $5 a bushel in May, but in June it could fall to $4. If a farmer believes the commodity price may continue to fall, he may offer a contract to sell all of his corn harvest at this $4 price on September 1st. In exchange for this price, he must deliver the corn by this date.

This is where speculation becomes very important in commodity trading. When September 1st arrives, the price of corn may have fallen to $3.50 a bushel. If this is the case, the investor has lost money and the farmer has profited. Conversely, if the corn rises back to previous levels of $5 per bushel, the farmer has lost money and the investor has profited.

Introduction to Commodities – Part 2

As part of our introduction to commodities, here we’ll examine an example commodity futures trade to further explain the process.

If you, the investor, purchase a commodity future to buy oil on the New York Mercantile Exchange (NYMEX) at $70 per barrel for West Texas Intermediate (WTI) by April 15th, there are numerous things to consider about this commodity trade.

First, a specific type of commodity is named – the trade not only specifies that you are buying oil, but that you are buying the product from WTI and not a different supplier. Various forms of oil with different levels of purity and shipping costs are available in futures trading, so some additional research and speculation is required here.

When you name the price of $70 per barrel, part of this price is called a ‘margin’, and must be paid when you name your price and date. Margin charges are typically 5%, but will vary depending upon what the recent price changes have looked like and other factors of consideration.

These contracts also will specify a unit or amount of the commodity to be purchased, and with oil this is typically 1,000 barrels. Now, let’s calculate the margin for this commodity trade: $70 per barrel for 1,000 barrels equals $70,000, and 5% of this amount is $3,500.

‘Leverage’ is the term referring to the fact that now, in this futures trade, you are controlling $70,000 of oil for an investment of $3,500.

You have chosen a contract expiration date of April 15th, when the contractor must deliver 1,000 barrels of WTI oil that fits your specifications. Some of these may include the purity or levels of sulfur in the oil product.

Now, when investing in these commodities markets, you never expect to be in actual possession of these 1,000 barrels of oil. You simply want to trade your contract for the oil; not the oil itself. Specialist commodity brokers ensure final contracts are adhered to by delivering the product to a consumer – in this case, it may be an oil refinery.

When trading commodities, remember these contracts state you must perform the stated action by April 15th or another specified date. In the meantime, the commodity market may fluctuate and cause your agreed upon price to change drastically in your favor or against it.

If spot market prices for the unit of WTI oil change during the contract period before the expiration date, this will affect the price of the contract. Let’s assume in this case that the price of a barrel of your specified WTI oil rises to $75 prior to your expiration date.

This means that your speculation and purchase at the $70 per barrel price results in a $5 profit per barrel you purchased on contract. Your total profit is equal to $5 x 1,000 barrels, or $5,000, and then subtracting your initial margin investment ($3,500) to equal $1,500.

To calculate the return on this investment, simply divide the profit by your investment amount: $1,500/$3,500 = nearly 43%; not a bad return rate at all! However, remember when entering the commodities market, the prices may fall just as much, reducing your profitability in the long run.

Types of Commodities Available for Trading

Prior to entering the world of commodities trading in futures contracts, it’s important to sufficiently research and determine which type of good you want to invest in. Categories of commodities are pre-determined to help in comparing prices between similar types, and this is a basic part of trading commodities that requires understanding before entering the market.

‘Energies’ are one of the most popular areas of commodity trading, and this category includes all products that provide energy sources to homes and businesses around the world. Petroleum and its products, including crude oil, heating oil, propane, natural gas, and coal are the most commonly traded.

For each of these commodities, they have their own ‘tick’ that outlines the minimum price changes as a result of the exchange activities, as well as an assigned standard size of contract. This means that each contract includes a certain volume or amount of units of the commodity in futures trading. For example, crude oil’s standard contract is for 1,000 barrels, and that for wheat is 5,000 bushels.

‘Grains’ are the next category of commodities that includes all agricultural products on multiple exchanges, and includes wheat, oats, corn, rice and soybeans. Byproducts of these grains such as soybean oil are also included in this category. Prices are subject to influence by the Chicago Board of Trade (CBOT), and the exchanges may trade the actual product as well as futures contracts on any of these commodities.

These products are also assigned a tick with the contract size and prices. Some of these product prices are expressed as dollars per ton or other unit when the standard contract is a certain number of the units, so make sure you understand what you’re reading.

‘Softs’ include consumer products such as coffee, orange juice, sugar and cotton. These are commonly named CSCE (Coffee, Sugar and Cocoa Exchange). When considering the case of orange juice, it is not the fruit that is actually traded on the futures market. The Frozen Concentrated Orange Juice (FCOJ) was created after World War II, and continues to be traded in the commodities market actively on a daily basis.

‘Meats’ are another category of commodities that is commonly traded, and includes beef, pork and poultry. Pork is further distinguished between lean hogs and pork bellies, which are used to produce bacon. These pork bellies are also largely influenced by the price of grain, since this commodity composes much of their regular diet.

‘Financials’ include U.S. Treasury Bonds and S&P 500 Index futures contracts. These financials are commonly listed on the Chicago Board of Trade index.

When perusing quoted prices in the indexes, you’ll notice that some will use abbreviations to express the expiration month for the said commodity. These are typically the following: January – F, February – G, March – H, April – J, May – K, June – M, July – N, August – Q, September – U, October – V, November – X, and December – Z.

This means that you may see a commodity futures contract listed as PBH07, or a pork belly contract expiring in March, 2007.