The futures market is a market where trades are conducted at the current moment, for commodities delivered in the future. For this reason, the commodities futures and options market is perhaps the most volatile of all the markets.
Leverage (using borrowed money to trade) and options (exercise your right at any time before the period expires) in futures further aggravates the volatility of results. Ultimately, commodities are traded by investors who know what to look for and are skilled in calling and putting (buying and selling at specific prices).
A greater opportunity for profits is always accompanied by a higher potential for loss (risk). There are some attributes that many successful commodities traders have in common. For those looking to get involved in commodities markets, it is important to understand the trademark characteristics of those who succeed.
A Willingness to Learn Futures and Options
Perhaps the most important exercise for those considering investing or trading in the futures and options markets is to spend lots of time learning the ins and outs of futures and the exchanges that offer these financial products.
There are many different commodities and financial products that trade on the two major commodity exchanges in the United States. The two exchanges are the Chicago Mercantile Exchange (CME) and the Intercontinental Exchange (ICE). Each of these exchanges offers a tremendous amount of material for those who wish to educate themselves.
Knowing the Margin Requirements
Required by many commodities, the margin is a good faith deposit required by exchanges on the products they offer for trading. Some commodities require a maintenance margin (payments if the value falls below a certain percentage).
For example, if a gold contract for 100 troy had a margin of $4,950 and a maintenance margin of $4,500, an investor would purchase the contract for $4,950 (the margin) while maintaining a value of $4,500 in the account (the maintenance margin).
This means if the value falls below $4,500, the investor must place more cash into the account or sell off shares to make up for the difference. This is called a margin call.
Have Insights on Commodity Frequencies
Some commodities trade throughout the year while others trade for specific months set by the exchange. Each contract has a different minimum tick value, representing the financial results of a minimum unit price change.
Additionally, many commodity futures have different specifications when it comes to making or taking physical delivery of the underlying commodity. Others offer only a financial settlement for long and short positions upon the expiration of the futures contract.
An Awareness of Commodity Attributes
Each commodity has a set of idiosyncratic attributes so it is important to understand exactly what a trader or investor is buying or selling. The exchanges offer an abundance of information on price, volume and open interest in each of the contracts they offer. It is important to understand this data and use it when analyzing these markets.
Use of Trading Platforms
Commodity traders generally select and use a trading platform that is comfortable, understandable and offers the services they need for their specific trading and investment activities.
An Understanding of Market Support and Resistance
Commodity prices, as with all volatile investments, tend to rise and fall with demand and supply. If demand falls, supply increases and prices go down. Once the lower prices begin to attract buyers, the price will fall until it finds a bottom (reaches the lowest level the market can support) and then begin to rise.
Prices will continue to rise (along with production) because demand has increased. This continues until a level is reached where consumer demand begins to decline due to high pricing. This is the point in which the market resists any higher prices, demand is lowered (market resistance), and prices begin to fall.
This cycle continues with supply, demand, and prices all fluctuating with respect to each other. Market resistance is a force that keeps prices from rising any further because buyers stop purchasing at a certain point. Market support is a force that pushes prices back up because there is enough demand to keep prices from falling lower.
This knowledge is used in both fundamental and technical analysis. Fundamental analysis is an attempt to understand the cyclical nature of a commodity market through the use of supply and demand data.
Commodity Traders and Fundamental Analysis
Commodities traders use fundamental analysis of commodities to determine the feasibility of purchasing or selling. Understanding futures, options, supply and demand, and their influence of these raw material markets is of primary importance.
Fundamental analysts tend to research total supply versus total demand in different commodity markets at different points in time, technical analysts spend more time analyzing historical data on charts and graphs.
Technical Analysis of Commodities by Traders
Technical market analysts study the behavior of prices in commodity markets by using historical price trends to predict the future trend. These technicians use charts with graphics to assist them in tracking price movements over time.
Some technicians look at very short-term price data—sometimes as short as one trading day—while others look at longer-term data such as a year to understand price behavior. Historical commodity closing behaviors are of most interest to the analysts.
Following the theories of supply, demand, resistance, and support, technical analysts look for and try to predict the points where the market resistance and support levels are going to present themselves. These points are generally the best times to buy and sell, as they reflect either the lowest or highest prices.
Therefore, technical analysis is an important component to understanding the current path of least resistance for prices and predicting the future.
A combination of fundamental and technical analysis, when used with a disciplined approach to markets can create the optimal approach to the commodities futures and options markets.
Discipline Is Critical
One of the most important attributes of a successful commodities futures and options trader or investor is discipline. Discipline in this respect is the ability to establish an investment plan and stick to it during the rollercoastering of the market.
Discipline with regards to trading is also the capacity to understand your own financial limits. You should never compromise your personal assets, or your ability to withstand a complete loss of investment. Good traders know when they can and cannot support a purchase or possible loss.
Successful traders never put all of their eggs in one basket. Diversifying your portfolio is one of the most recommended actions for traders and investors. Having a diverse portfolio means having some investment in different markets and commodities, not just one.
Many traders have a habit of adjusting their risk to reward by placing stops on long and short positions. A stop is an order to quit buying or selling at a price named by the investor, to attempt to buy and sell at "right" price, to ensure optimum profitability.
Commodity Products Outside the World of Futures Exchanges
In the last few decades, exchange-traded funds (ETF) and exchange-traded notes (ETN) became popular. ETFs are equity equivalents of physical products, which replicate the price performance of products traded on the exchanges. This allows traders to trade on commodities without holding the physical asset.
ETNs are more similar to bonds, where the note is purchased for an amount less than the face value, and upon maturity, the issuer pays the face value minus fees.
An understanding of futures exchanges is still necessary when trading or investing in these market vehicles. Fundamental and technical analysis, along with the principals of discipline still hold true when it comes to a successful approach to the ETF and ETN markets in commodities.