How Do You Trade Commodities?
How do you go about trading commodities like coffee, sugar or crude oil?
If, for example, you think that the price will go up, do you have to buy the physical product
and store it in your basement? Well, you could but there are a few problems with this approach. To begin,
the transaction size in the physical commodity markets is large, thousands of times larger than that to which you, as a typical
consumer, are accustomed. If you buy the physical commodity, you will have to pay the full price and that
will tie up a lot of cash. Then you will have to find a place to safely store the commodity and this will cost money
as well, as will insurance in case the commodity suffers damage. Finally, youīll have to pay shipping and freight charges
both to take possession of the commodity after purchasing it and then, when youīre ready to sell, delivering the commodity to the point of sale.
The costs associated with all of this will eat into any profit that you make on the physical commodity transaction, but that
is not the biggest drawback to trading the physical product. What do you do if you expect that the price of the commodity
will fall? How can you go about trading that price expectation with a physical transaction?
Because of the difficulties described above, few people who desire to profit from changing prices (called speculators)
trade physical commodities. Instead, they trade a financial instrument whose value moves essentially in step with the
price of the physical commodity. These instruments are generally referred to as derivative products since their value
is derived from price movements of the underlying commodity. For retail traders wanting to participate in the commodity
markets, the most important derivative products are commodity futures, commodity options by which it is meant options on
commodity futures, and binary options which are usually based on the corresponding commodity futures.
This site will provide information on trading commodity futures. Information on trading commodity options can be found
on our specialty site, How to Buy Options,
and information on trading binary options can be found on our specialty site, Binary Options Training.
Why Trade Commodity Futures?
Trading commodity futures is much more efficient than trading the physical product. In fact, in many cases, trading activity
or dollar volume is higher in the futures market than in the physical market itself and the futures contract, even though it is
a derivative product, actually provides the price discovery function for the commodity itself. Crude oil is an example of this.
What are the advantages of trading commodity futures? To start, a commodity futures is just a legally binding promise to
acquire the physical commodity (if you bought the futures) or deliver the physical commodity (if you sold the futures) at
some point in the future when the contract expires and this may be weeks or months down the road. In other words, the transaction is deferred and because
of this, it has several advantages over a spot or physical transaction that requires immediate delivery. For example,
since there is no immediate exchange of physical commodity for cash, you do not need cash equivalent to
the full market value of a commodity futures contract to buy
the futures contract. You will, though, need a small portion of this value - usually less than 10% - to show your financial
ability to handle the risk of the trade and this cash is referred to as margin. You can read more about margin in
Understanding Commodity Futures at right.
Since a commodity futures is a deferred contract, it is a simple matter to sell a commodity that you do not own, say, in case
you expect the price to drop. This is referred to as selling short and can be done because, with a commodity futures, you
donīt have to have the commodity in your possession upon futures sale. But donīt you have to acquire
the physical product at some point in order to satisfy delivery of the short futures position? Yes, but only if you intend
to hold the short futures position to contract expiration. For a retail trader who is just looking to profit from
price changes, you will not do this. Instead, you will close the short futures position by simply buying a futures contract on
the same commodity and having the same expiration. Upon doing so, you will have closed the futures position and there will
be no further obligation on your part to deliver the commodity. You are only left with the net profit or loss on the
completed commodity futures trade.
Trading Commodity Futures
How does one go about trading commodity futures? Commodity futures trading within the United States takes place on
government-regulated commodity exchanges. The exchanges provide the commodity marketplace. To access this marketplace,
you will need the services of a commodity broker. Upon finding a broker, you will then need to open a commodity trading
account and deposit funds into the account in order to cover the margin requirements of the commodity contracts that
you wish to buy or sell. For more information on the function of these market participants and others, please see
The Commodity Futures Market at right.
Before you actually start trading commodity futures, you need to educate yourself to decide if this is something that
is appropriate for you. Trading commodity futures entails risk of loss and is therefore not appropriate for everyone.
Reading the information on this site is a good first step but please donīt stop there!
Your next step...
Congratulations! You have already started to learn commodity trading. For your next step, please watch our
free one-hour proprietary video, Commodity
Trading - A Plain-Language Video Introduction. Designed for someone with little prior industry exposure, this topical video will
carefully navigate you through some of the more pertinent aspects of commodity trading.
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