Friday, January 16, 2009

Commodity Trading for Beginners

One of the things I had planned to do when starting this blog was to teach commodity trading for beginners. I started realizing that there are so many people out there who are just like I was when I started trading—absolutely clueless (LOL). The type of knowledge required to trade commodities or futures is what (I guess) can be called “specialized knowledge”; in other words, it’s not knowledge that’s picked up just by living your life; you have to actively pursue the knowledge to even gain a basic understanding of the futures markets. Since most people haven’t studied for a Series 7 license or whatever, I thought it would be good to explain some of the basics of futures trading so that it can be easily understood to the novice. One of the things that I hope to achieve with this blog is to have something that I didn’t have when I started trading—a place to get knowledge about the futures markets fairly easy, instead of doing hours and hours of research on the Web to find out different nuances of the futures markets—it was much like looking for a needle in a haystack many times. Talk about frustrating…but really, through nothing more than trial and error (and a WHOLE LOT of reading on the Web) I gained a basic knowledge of the futures markets, opened my account with just $1,000, and haven’t looked back since.

One of the things I have learned through my experience in the markets is that many people have failed to grasp even the very basic parts of commodity trading, including the trading symbols. See, the futures market is much like the stock market, in that the instruments that are traded on the markets have symbols that represent what each particular futures contract is. The ticker symbols of the stock market are for the most part longer than the symbols for the futures markets, since there are far less instruments being traded on the futures markets than in the securities market, but the volume is MUCH larger in the commodities market than in the stock market, meaning, a whole lot more money changing hands. At any rate, as an example, the symbol for Corn is “C”, the symbol for Wheat is “W”, the symbol for Rice is “RR”, the symbol for Lean Hogs is “LH”, etc., etc…it’s actually too numerous to list here. Since I’m definitely not one to re-invent the wheel, I’m just going to refer you to Barchart’s list of commodity symbols at this link: Basically, the symbols are what you’ll see when looking at commodity price quotes, and the usual format they follow is the futures symbol, then the contract month (explained below), then the contract year. For instance, if I was trading a December 2008 Corn contract, I would see this symbol on the futures quote list: CZ08. The “C” is the symbol for Corn, then the “Z” is the symbol for December (each month has its own letter symbol as well), then “08” is, of course, the contract year. Meaning, that contract is valid up until what they call the Last Trading Day (LTD) in December of 2008. At the point that the contract expires, if you haven’t yet offset (or exited) your position, you will be obligated to take delivery of 5,000 bushels of Corn (if you were long), or to sell 5,000 bushels of Corn to someone else (if you were short). Remember that a long futures contract is simply a contractual obligation to buy a set amount of a certain commodity at a fixed date in the future (hence the name), and a short futures contract is a contractual obligation to sell a set amount of a certain commodity at a fixed date in the future. The markets were actually created to help large commercial users of commodities (think General Mills for Corn & Wheat, think major electrical wiring companies for Copper, etc.) as well as farmers and other commodity users have an orderly place to do business and exchange goods. Think about it: If you were making some bread and you realized that you had run out of flour, you would simply go to the nearest grocery store and buy a bag of flour. But huge commercial producers such as Gold Medal Flour can’t operate with that same lack of planning, or they would soon be out of business. So they basically place an order for X number of bushels of wheat (to make the flour) through a commodity exchange by way of a futures contract. They may not want or need the wheat right now, but they will anticipate how much they need a few months down the line and place an order for FUTURE delivery of the wheat, by way of a futures contract. They will purchase the contract through a futures broker at the prevailing market price for wheat—let’s say that wheat is currently trading at $4.50 a bushel (the standard contract size for wheat is 5,000 bushels). Once they purchase the futures contract, they have done what’s known as “opened a position” in the Wheat market, which basically enables them to "lock in on" the current price of wheat, even though it can change for the better or for worse. The price of wheat futures will fluctuate on a daily basis, due to the fact that it is indeed based on FUTURE delivery, not wheat that you are carrying home the same day you purchased it. Since nobody knows the future, and several factors that affect wheat prices can come into play between the time the futures contract is purchased and the time that the contract is up for expiration (and delivery), the price of wheat futures will continue to be volatile. This is what creates opportunities in not only the Wheat market, but every other market as well. These price fluctuations that happen throughout the life of a futures contract can either put tons of money in your pocket or extract tons of money out of it.

I’m extremely sleepy right now (it’s really late here), so although I feel like I gave a somewhat half-baked explanation of the basics of futures trading, I will continue along these lines of explaining commodity trading for beginners…hopefully someone will learn something along the way.