Trading commodities online is a relatively simple process, but it is not an activity that you should pursue without doing lots of homework.
The traditional method of calling a commodity broker to place orders and waiting for a call back to give you a filled order price is less efficient than online trading. Therefore, if you want to trade commodities online, there are some important factors to keep in mind.
Choosing a Commodity Broker
Commodities trading nowadays is either accomplished through the use of ETFs or through the buying and selling of futures contracts. Several online retail brokers offer trading in both of these types of securities, however, some brokers specialize in futures trading. You should research both kinds and determine whether you want the extra services and tools that come from brokers offering specialized futures trading, because those items come at an additional cost. Other online brokers, such as Interactive Brokers, offer excellent products, good service, and low commission rates.
Commodities Account Paperwork
Every commodity broker requires documentation to open an account. The forms require disclosure of financial information and identify the risks involved in trading commodities.
Financial data is critical because commodities are highly leveraged assets (borrowed money for funding). As such, there is always a chance that one can lose more money than initially invested. Therefore, a broker will require information on income, net worth, and creditworthiness to determine if they want to work with you.
Sufficient income, trading experience, and credit are critical elements when a broker considers your suitability. Not everyone who completes the account forms is suitable to open a commodities account. A broker may use discretion as to whether a potential customer is an acceptable risk and is suited for commodities trading.
Before You Start Trading Commodities Online
Once you select an online commodity broker, and you receive approval for trading, the next step is to fund the account. While many brokers have minimum limits, it is up to the individual to determine the amount of funding over the required minimum when you open an account. One's comfort level and risk tolerance are important considerations when funding an account.
Before you commence trading with actual money, it is important to develop a well-researched trading plan. Many commodity brokers offer simulations to practice with before you put capital to work. Training and simulations will familiarize you with placing orders and could save you from making critical order entry errors.
Simulations also help you develop a feel for trading, and help you conceive a plan for approaching the markets in which you want to trade.
When you begin trading commodities online, choose your trades wisely and avoid overtrading. Start small, and work with one at a time. If you find yourself placing many trades from the start, you might be getting in too quickliy, which can increase the probability of failing and losing money.
Advice for New Online Commodities Traders
It is important to understand what the futures and options markets are comprised of. They are derivatives of the actual commodities market, where the physical delivery of the commodities takes place. A derivative is simply a security that is based on an underlying asset, in this case, physical commodities.
Therefore, it is important to learn all you can about the underlying supply and demand fundamentals for that commodity and the derivatives that are being traded. There is a wealth of information available for free from the commodity exchanges and trade organizations. Government agencies supply commodity data free of charge.
In the energy markets, the API and EIA (American Petroleum Institute and Energy Information Administration) are excellent sources of information. In grains, soft commodities, and animal protein markets, the U.S. Department of Agriculture issues weekly and monthly reports that include invaluable data and analysis.
Understanding commodities will require paying particular attention to supply and demand. It would also be beneficial to learn how to research changes in the supply and demand of various commodities. For example, learning how to read and understand the crude oil inventories report published weekly by the U.S. Government's Energy Information Administration, would be a good place to start if you want to trade oil futures.
The futures and options markets in commodities are laden with risk. There is a tremendous amount of leverage in these instruments. While the opportunity exists to make huge gains, the potential for rewards is accompanied by high risk.
Trading Futures and Margin Calls
Trading in futures requires a good-faith deposit or margin (a balance that must be maintained—the maintenance margin). Commodities are a very volatile market. Margin calls requiring additional capital are likely—in the event that the value of your investments drops too much, your broker may initiate a margin call.
A margin call happens when a broker requires you to put more capital into your account because values have fallen below the minimum required equity balance you have to maintain.
A trader who stays at this level of trading is "trading on margin," a very risky and costly way to trade. If you do not have the capital to support the financial hits, it can require borrowing more money every time you lose money. Many traders lose a tremendous amount of money trading on margins.
Exercise caution in the commodity markets, do your homework and approach these volatile instruments with care and trepidation. While fortunes can come from commodities trading, the potential for losses is just as great.
Online trading has increased the speed and efficiency of execution. Remember to approach online trading as a business—with a plan, discipline, and precision. Mistakes can be very expensive, so work to keep your trading to a minimum.
The most successful traders are masters of efficiency. Mastering online trading requires a level of expertise that comes from hard work and study. Make sure you use all of the information that is at your disposal. The platforms want you to succeed because a successful customer makes them successful as well.
Lastly, since all commodity futures trading is leveraged and requires the use of margin, you should diligently research and seek education on the rules and effects of trading futures with margin. You should clearly understand how much money you could lose in that environment. You should also research how to minimize the risk of loss while you are trading and spend many hours practicing and honing your skills before you put any money at risk in the endeavor.
Frequently Asked Questions (FAQs)
How should you start trading commodities if you only have a little money?
Paper trading with a demo account doesn't cost a cent, and it teaches you valuable trading skills. If you want to use some money, but your funds are limited, then you may want to stick to commodity ETFs, since ETF trading typically comes with fewer fees than options and futures trading. ETFs may also allow for fractional trading. However, if you want to day trade actively, then futures are your only option until you have the $25,000 required to satisfy pattern day trader restrictions.
Why is insider trading allowed with commodities?
It's important to distinguish between insider trading and trading fraud. In commodities, as with stocks, people involved in an industry are allowed to trade securities related to that industry. Many industry insiders use futures to hedge against the inherent business risks and keep the cost of raw materials more consistent. An airline company might use futures to lock in the price of fuel. However, insiders who trade commodities with nonpublic information, arrange noncompetitive trades, or otherwise engage in fraud could face serious legal consequences. In 2021, for example, a grand jury in Texas indicted a natural gas trader with multiple counts of commodities fraud—each carrying the potential of up to 25 years imprisonment.