Wednesday, October 1, 2008

The Basics of Commodity Trading

You know, the more I have pondered over the type of things I wanted to write about with this blog, the more I realized that what is generally lacking in this arena is just the basics of commodity trading. The world of futures trading seems to be a mystery to most, or something that only an elite few people really know or understand how to do with any kind of true proficiency. It’s a sealed book to most people who are just starting out, and it’s almost like you have to have some kind of educational background in the financial sector to really “qualify”, so to speak, to trade commodities, or any other derivatives type of financial instrument. The funny thing is, the more you get into it and actually begin trading commodities, the more you realize that it’s really not as sophisticated as those on the inside would have you believe. Yes, there is an element in the world of futures trading that thrives on appearing “exclusive”, but at the end of the day, all it boils down to is that you place a trade, you wait for it to do something that hopefully makes you money, and then you close the trade out. End of story. It’s really no more complicated than that. There are a lot of futures analysts and commodity trading analysts, and there are those who specialize in forecasting certain markets such as the meats, grains, etc. based on fundamental data, and the list of pundits and talking heads goes on and on. Still, at the end of the day, you place a trade, you either make money or lose money, and then you get out of the trade. It is that simple.

So what are some basics of commodities in general? I have already explained what types of commodities are traded on the open market. The cool thing about trading commodities is that it is a survival industry; it’s not like a penny stock that can come and go; you’re dealing with raw goods that pretty much everyone on the planet uses or has need of in one way or another. Think about it: Wheat ain’t going nowhere. Gold isn’t going anywhere (better grammar on this one). Corn ain’t going nowhere. Cotton ain’t going nowhere. People will be drinking orange juice, no matter how bad the economy gets. They’ll be eating wheat, rice, corn, etc., no matter which direction interest rates go. So again, it is a survival industry. And the type of price patterns and trends that happen in the commodity markets are definitely evident and predictable over time. Once you’ve been trading long enough, you begin to develop a “feel” for each of the different markets, and how they generally behave. You can look at a commodity’s daily price and tell whether or not it’s high or low, based on your understanding of the price history of that particular commodity. I highly encourage every trader to study historical price charts, and notice the general range in which most commodity prices have traded over time. Of course, most of this has been completely skewed by the recent spike in almost every commodity across the board. Those of us who have been trading for years now (I’m seven years into it myself) can attest that there hasn’t been anything in the past that is quite like the way the markets are behaving right now. Of course, there also hasn’t been the exorbitant amount of speculation in the past like there is now. The futures markets, for lack of a better term, are way more “popular” now than they have ever been in the past. This has caused the large institutional investors (banks, insurance companies, etc.) to move more into the realm of commodities, and due to the sheer size of their trading capital, they can pretty much move markets in whatever direction they please. If you need an example, look at the way crude oil futures have been behaving for the past year or so. I’ve never seen anything like it in my seven years of trading. I remember when I first started trading, not too long after 9/11, that crude was only $13.00 a barrel. Can you even believe that??? It was almost inconceivable that in only a few short years, crude would break every record known to man and zip into the $100.00-plus-per-barrel range. When it first started hitting, I knew immediately that speculation had truly begun to run rampant, and that there was no way that this type of wild price behavior could be tied to any real fundamental data. For the most part, fundamentals are crap anyway. They’re almost always a day late and a dollar short, as far as helping to determine which direction the market may move. This is where we get the axiom “Buy the rumor, sell the fact” from. It pays to study charts, and to understand that all of these commodities move in somewhat predictable patterns (for the most part, anyway). Anyone who thinks that they can just waltz into commodity futures trading without doing their due diligence will soon smart for it. There are a whole host of factors to consider when entering into the arena of commodity trading, most of which have to do with internal issues, not external ones. The market forces will be the market forces, and there are so many nuances to each market that it’s very difficult to nail down one specific “culprit” that causes futures prices to rise or fall. Rest assured, however, that the commodity charts reveal all. If I could name one cornerstone to being a successful futures trader, that would be it…the chart is king. Price action rules. There is no better indicator of what’s really going on in a given commodity market than the price chart. It’s only by studying the past that we can get an insight into the future. Remember the famous adage—“Those who don’t know their past are doomed to repeat it”. This holds true in the futures markets as well. So many booms and busts have happened in the past—think of the Hunt brothers Silver debacle, the recent runaway crude oil market (which, by the way, is driven by about 90% speculative forces), the fairly recent runaway metals markets (gold, silver, copper, etc.), and you’ll notice that human emotion, greed, fear, avarice, and flat-out mania control the markets more than anything else. Think of the great trader Jesse Livermore—he capitalized on the emotional mania of the 1929 Wall Street stock market crash, and subsequently made over $100 million dollars shorting the market. So while some people were jumping to their death from tall buildings on Wall Street, and while the prices of stocks all over were plummeting at lightning speed, Livermore’s net worth was rapidly increasing. It’s all about perspective.

Okay, I have gotten off on a serious tangent again…this post is already very lengthy, so I’m going to sign off for the time being. Just keep in mind that the charts should be the final authority in your trading decisions. Price action is absolutely king. With just these two commodity trading basics in mind, you’re already starting off on the right path.

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