Commodity Trading Basics

Commodity Trading Basics

There is a huge amount of online information available about commodity futures trading. Some of it quite valuable, some not so much. Our purpose is to provide an educational forum for all futures traders, not just beginners. Throughout these pages you will find many market ideas and tactics of value to all experience levels. Still we believe that one should always start at the beginning. Below you will find some commodity trading basics that traders can use to develop their trading plans.

Settlement

At the most basic level a futures trade is a legally binding agreement to buy or sell a commodity or financial instrument at a later date. Futures contracts are standardized according to the quality, quantity and delivery time and location for each commodity. While most traders exit these contracts before they come due (usually referred to as expiration), there are certain aspects to the settlement of outstanding contracts that a trader needs to be aware of.

There are two basic types of futures settlement, cash and delivery. Delivery is probably the most commonly recognized form, but not necessarily the most prevalent. As the name implies, delivery means that the buyer (long) will be presented with a certified receipt representing the underlying commodity or financial instrument in return for the full value of the specific contract. For example, an individual taking delivery who was long March soybeans at $11.00 would be presented with a certified receipt for 5,000 bushels of beans stored in a warehouse certified by the Chicago Board of Trade. In return, he would pay the seller (short) $55,000. To avoid taking delivery on a futures contract, a buyer (long) needs to exit his/her position before what is termed First Notice Day. That date represents the first day that a seller (short) can deliver the underlying physical commodity or financial instrument to the buyer (long). As First Notice Day differs from one market to the next, it is important that traders be aware when that specific date is. Sellers (shorts), unless they intend to deliver the underlying physical, need to be out of their position by expiration day.

An easier and increasingly more common way for settlement in financial futures is referred to as cash. In this case the contract settles for an amount of money equal to what the derivative’s market value would be if it were physically settled. Trader’s positions are then simply offset at the expiration price. Consequently traders with positions in cash settled markets at expiration have their account balance adjusted to reflect the closing price on the last day of trading. Such a method is common in markets where physical delivery would be difficult or overly expensive to implement. For instance it would be cost prohibitive to actually deliver all 500 of the stocks traded in the S&P industrial index.

Trading Strategies

As with most things in life, to be successful as a trader you need to have a plan. At this juncture it would behoove us to spend a little time and cover some of the basic approaches that different traders can take in analyzing market opportunities. Trading strategies can be broken down into three basic categories, fundamental, technical, and contrarian. While technical analysis has probably been the most popular over the last several decades, the recent growth in information technology has led to an explosion in the amount of resources available to traders in this area of study.

In its most basic form, technical analysis is the examination of price series data for consistently recurring patterns. Most often data is graphically displayed in a standard bar chart format. This consists of a line connecting the high and low, with a small mark placed on the left for the open and the right for the close. Each bar represents whatever specific timeframe the trader is interested in studying and generally ranges from between 5 minutes to 1 month. Often below the price chart analysts will plot volume and open interest. There are also numerous mathematical renditions of the price data that can be overlaid or plotted below the chart, such as moving averages, oscillators and the like. The following bar chart shows December 2012 silver with a volume and open interest plot.

silver chart with volume and open interest

Daily Silver Chart

A technical analyst will study charts for certain patterns or apply tools such as moving averages or trend lines in an effort to help make trading decisions.

A fundamental analyst will study the basic underlying supply and demand factors that can be expected to influence price. Such information as the size of the soybean harvest, what was left from last years crop (referred to as carryover), expected exports, and feed use will all come into play in helping make trading decisions. When a fundamental analyst sees an imbalance in these types of factors he will develop a trading plan accordingly.

supply and demand fundamentals

Corn Supply and D

The table above shows the USDA soybean supply and demand report for Feb 9, 2006. From a logical viewpoint there is a certain allure to the idea of trading markets on a fundamental basis. And while there are certainly many excellent traders that have made their fortunes utilizing this method of trading, there are several drawbacks to this approach. To begin, one of the most critical elements of successful trading is cutting losses short. Basically what that means is that you need to know when you are wrong relatively quickly. When using a fundamental approach, the forces of supply and demand are difficult to measure and consequently significant changes are not necessarily easy to detect. As a result, a market can move significantly before the fundamental reason is known. Another drawback is the fact that once fundamental data is released, everyone knows about it. It is very difficult to come out ahead in the futures markets if you are acting on news that everyone else knows. Due to these limitations even hard-core fundamental traders must use some form of technical analysis to manage risk.

The third category of approach that a trader can use is called contrary opinion. The theory behind it is that when everyone that is going to buy has done so, there are no buyers left to maintain the markets upward momentum, and thus price must fall. The reverse logic follows on the short side. Contrarian’s will use private reports and the Commitment of Traders data to gage market sentiment.

Understanding Commodity Trading Basics

To understand the intricacies of futures trading is a difficult task. Commodity Trading Basics is a platform for all to nurture and improve their knowledge of the subject.