Commodity Trading: Price Discovery is Dead

First of all, I want to extend my deepest condolences to every family that was affected by the Sandy Hook tragedy. I am a parent of young kids, and my heart truly grieves for those parents who lost their children. I can't even imagine the pain they're going through, and my prayers are with them.

I know it’s been quite a while since I’ve put anything on this blog, and I’m amazed at how fast the time has flown by. Life has been a whirlwind for sure. The passage of time has really put some things in perspective as far as this blog goes. I started it just to talk about the commodity futures markets in general, and my goal was to share practical information about the markets and the way they work, as well as some information on trading the markets, geared especially towards the beginner. When I first started trading back in 2001, there was no such website that I knew of that provided practical information (in plain English) about trading commodities, so I figured that if I could provide new traders with some solid info on the markets that could possibly cut a lot of time off their learning curve, so much the better. My learning curve cost me a lot of money, and I have some serious battle scars from being in these markets, so I figured that others could learn from my experience and mistakes.

When I first started trading, Corn was in the low 200’s, Gold was in the high 200's, margins were somewhat reasonable for the metals in general, and it was actually a significant thing to have “beans in the teens” (i.e., Soybeans trading at 1300 or higher). Price movements were much more “reasonable”, if you will, on a general basis…there simply wasn’t as much crazy volatility happening at the frequency that it happens nowadays.

It really seems like EVERYTHING has changed about the futures markets, and NOT for the better. Honestly, the markets of today seem completely alien to me, and in a way it feels like losing a close friend. What do I mean by this? I have spent the past 11 years studying, tracking, and (sometimes) trading the commodity markets, both futures and options contracts. I have spent literally thousands of hours analyzing price charts of all kinds. All of this aggregated information and experience has led me to a very unpleasant conclusion: The futures markets of today are nothing but a hollow shell of what they used to be.

Let me explain:

The very reason for the existence of the futures markets is to carry out a function called “price discovery”. What this means is that markets were intended to be a place where buyers and sellers could have a medium to facilitate the process of exchange for vital commodities of all kinds. If a cereal company needed corn to make its “Corny Puffs” or whatever, it could buy a futures contract to lock in a certain amount of corn at a certain price, to help curb the uncertainty of price increases months down the road. By the same token, farmers could use the futures markets to lock in a certain price for the sale of their goods (such as corn) by going short (i.e. selling a futures contract), so that way they would be guaranteed some protection from loss should prices fall in the future. This is a very over-simplified version of what the markets are all about, and I’m sure that there are much more sophisticated explanations out there; I’m just not interested in being hyper-comprehensive right now. The bottom line is that the futures markets are (well, were) used to facilitate price discovery, meaning that the constant activity of buying and selling in the markets would regularly guide the prices of the futures contracts being sold in the markets. You had the “open outcry” format happening in the majority of trading pits, which conjures up images of the movie “Trading Places”, where dudes are screaming at each other and order tickets are flying in the air all over the place. This “organized chaos” was the norm, and markets had more of a human element to them, because humans were still the main entity trading the markets at the time; computers had not yet fully come into the picture. Of course, by 2001 there were some burgeoning trading technologies being built, but nothing like the techno-monsters of today’s trading world. The development of high-frequency trading (HFT) computer technology has literally exploded over the past 5 to 10 years, and this development has completely changed the landscape of the futures markets. 

What do I mean? Simply this: Our futures markets, and the prices of the commodities that are being traded on them, are now completely governed by sophisticated high-frequency trading computers, used primarily by large financial institutions such as hedge funds and investment banks. These large financial entities have the deep pockets and influence to recruit some of the smartest technological minds on the planet, and these minds are assembling computerized trading programs that can buy and sell hundreds and thousands of futures (and options) contracts multiple times in milliseconds, something that a human being could never do. The buying and/or selling “decisions” that these computers make are based on proprietary trading algorithms that look for “signals” of all kinds to determine what move to make next. These signals are based on news items, market volume, and a host of other factors much too complex for me to wrap my mind around. These HFT programs have all but completely wrecked the markets, because authentic price discovery cannot take place in an environment where thousands of trades are placed in nanoseconds—the information is simply moving faster than we have time to analyze and process it. When virtually mindless computer programs have the ability to govern the prices that ACTUAL GOODS are sold for, this affects ACTUAL HUMAN BEINGS. Markets, at the end of the day, exist ONLY to service human beings. We need these commodities to function in any kind of developed society, but when the price of a commodity can shoot to the moon OR drop like a rock in a matter of seconds due to a bunch of mindless trading programs getting the same “idea” at the same time, this creates a very unstable trading environment, and consequently a very unstable economic environment.

The problem is that practically everything in the world is affected by commodity prices. That’s a bold statement, but it’s very true. Didn’t our entire economy get thrown into a tailspin when Crude Oil was trading at $120 a barrel back in 2008? What nobody will tell you is that the spike in price had NOTHING to do with supply and demand fundamentals; it was the HFT programs that ran the price up to that level, with Goldman Sachs leading the charge as usual; they manage to show up at practically every party where financial improprieties take place. I believe that the unintended consequences of these HFT programs hasn’t even fully been realized yet, and this post-2008 meltdown we’re living in now is only the tip of the iceberg as far as negative financial impact is concerned. We’re in for some very rough sailing, folks. Now that these “franken-trading” programs are the dominant force in the markets, in my mind true price discovery is completely dead. Trader Dan touched on this problem of market instability in a post he wrote back in April, and I encourage you to check it out. The emergence of “flash crashes” has become a very real problem as well—this is when a very sudden drastic price drop happens in literally nanoseconds. Check out this post by Zero Hedge outlining a series of recent flash crashes due to HFT programs. While you’re at it, check out this article too about how even nanoseconds are an eternity to some of these high-frequency trading programs. That one concept, for all intents and purposes, makes the markets completely unnatural. And when very natural human beings have to live with the consequences of commodity prices being governed by very unnatural trading programs, you’ll see very unpleasant results.

The markets are no longer a reasonably safe place for the small speculator. They are completely dominated by HFT algorithms. I no longer even trade futures contracts for this reason; I believe in choosing my battles wisely. Options are a much better choice nowadays due to the limited risk. If you want to commit financial suicide, stroll up into the markets with your puny $50,000 account thinking that you’re going to run the world. You will quickly be disposed of professionally, and I hope that you walk away with a lesson in humility.

Commodity Trading Basics (Part 3)

Any time you want to discuss commodity trading basics you’re going to have to mention the importance of developing a disciplined trading methodology, and applying sound risk and capital management to your trading habits. There’s no way on God’s green earth that you can expect to have any longevity trading in the futures markets if you neglect to discipline yourself to stick to a well-thought-out trading plan. And this applies to any market; I could be talking about oil trading basics, or corn trading basics, or any of the other derivatives; it really doesn’t matter which particular market you choose, the importance of developing a sound, reasonable trading plan. This, surprisingly, will be the most difficult part of your trading career. Truth be told, if you never settle this part of your trading career, you won’t have a trading career after long. A fool and his money are soon parted—so are a trader and his money if he doesn’t have a well-thought-out trading plan. So you may be thinking “What should I include in my trading plan?” Well, for starters, you need to know how much total capital you want to start with. Most commodity trading advisors recommend starting with no less than $50,000, but this number greatly varies. I didn’t start with anywhere near $50,000. I started with $1,000, and quickly blew that account completely out. When I started again, I started with $4,000 and did much better. Looking back on it, I would never have started with less than $10,000, knowing my own personal risk tolerance and personality. That’s the part that really no one can teach you, is how much money you can handle putting at risk. Many people trade way beyond their emotional tolerance level—in other words, they’re overloading their emotional capacity by risking WAY more trading capital than they’re comfortable with losing…and the one thing I’ve learned over the years is that you NEVER risk more money than you’re willing to outright lose. If you can’t kiss it goodbye without missing it, you will never trade successfully. The chance of that happening is always there, and anyone who’s ever been caught on the wrong side of a limit move can tell you that it’s there.

Commodity Trading Basics: Limit Moves

As an aside, for those who may not know, a “limit move” is when a market moves its absolute maximum in one trading session, up or down. The commodity exchanges have set limits on price moves so that there will be no extreme “runaway” markets in one day. Can you imagine if speculation went completely wild in a trading session, and Wheat moved up 200 cents in a trading day? That would be a $10,000 loss (per contract) in ONE DAY for the guy who’s on the short side of Wheat—talk about no fun!!! So, the exchanges implemented a “limit move” restriction on prices for extreme trading conditions—when a limit move occurs, you’ll see a little horizontal “tick” on the price chart—it looks like a little hyphen—with nothing else around it. If prices move up to the daily trading limit, it’s known as going “limit up”. If prices move down to the daily trading limit, it’s known as going “limit down”. For instance, (if memory serves me correctly) there was a time back in the 1970’s where soybeans skyrocketed, and went limit up for consecutive days. It would suck horribly to be on the short side when a commodity is going limit up, and it would suck horribly to be long when a commodity is going limit down. Many a trader has been wiped out by limit moves; that’s why it’s always good to protect your positions by buying options that are opposite of your position. For instance, if you’re long Coffee, you could buy a put option at or near your entry price to partially shield you from downside risk, or if you’re short Oats, you could purchase a call option to partially protect you from getting caught in a violent upswing in price. As far as the details of these types of trades, we’ll have to cover them in future posts…this one is long enough already (ha ha).

Well, I wasn’t expecting to go off on the “rabbit trail” regarding limit moves, but since this blog is about commodity trading basics, it didn’t hurt at all to cover them the way we did. Hope you got something out of it!