Introduction to Commodities Trading

For nearly as long as humans have been specializing, focusing on producing one product while someone else produces another, there has been some form of commodities trading. While it originally was more like bartering, trading one commodity – corn, beads, gold – for another – sheep, horses, wool – the premise is very similar to what goes on today in the commodities market. One of the biggest differences today is that most commodities are traded utilizing futures contracts. Commodities trading with futures contracts can be very lucrative but also quite risky, compounded by the use of leveraged trading.

Commodity Trade Example

The easiest way to explain a futures contract on commodities is with an example. Imagine that in March, a merchant is planning his purchases for the fall. He wants 100 bushels of wheat and is trying to estimate what the price will be. At the same time, a farmer is wondering what price he will get for his wheat at harvest. The two men get together and decide that the merchant will buy 100 bushels of wheat from the farmer at harvest for £1000. They agree on the commodity to trade, condition of the product and have negotiated a price and thus have entered into a futures contract.

How a futures contract becomes profitable works like this. Let’s say now that it is nearing harvest time and it has been a great year for wheat. All of the wheat farmers have an abundance of wheat and the current market price for wheat is £8 per bushel. That would mean that 100 bushels would cost £800. Since the farmer from our example has a contract for £1000, he sees a £200 profit on the contract since he is selling product valued at £800 for £1000. Alternately, he could purchase 100 bushels for £800 from another farmer, deliver it to the merchant, and still make £200.

If on the other hand, it was a bad season for wheat and the price per bushel went up to £12, the merchant could take the wheat he purchased for £1000 and re-sell it for £1200, making £200 in profit. Or, the merchant could choose to sell his contract to purchase 100 bushels for £1200 and earn himself £200 that way as well.

Modern Commodity Trading

Today, most people who purchase futures contracts for commodities have no intention or desire to actually receive the promised goods. Commodities traded include physical objects such as precious metals like gold, silver and platinum, agricultural products like corn, soybeans, cocoa and coffee, livestock such as pork bellies and cattle, energy products – ethanol, crude oil, natural gas for example, and other items. Futures contracts may also be made for currencies, securities and intangible items like stock indexes.

When buying a futures contract, you are said to be long, while sellers are said to be short. For instance, someone purchasing a futures contract for crude oil is long crude oil, while the seller of the contract is then short one contract for crude oil.

Commodities are Traded on Margin

Futures contracts are generally not traded on cash, but instead on margin. This is called leveraged purchasing and is one of the reasons that commodities trading can be quite risky. With leveraging, the trader is only required to put up a small amount of money relative to the amount of commodities he can control with his account. Margin accounts must be approved by the regulating body and must maintain a certain percentage of cash in them in relation to the value of the commodities held by the account.

For instance, if a trader wants to purchase a futures contract for £100,000 worth of crude oil, he might only need to put up £10,000 in his margin account to control this amount. Although futures contracts are held for some time, they are settled, or marked to market, every day. This means that on a day-to-day basis, the contract is settled at the current market price and one party may see a loss while the other party might see a gain each day. Because the contract was purchased on margin, both the buyer and the seller must settle their margin accounts if any loss exceeds the minimum margin requirement for their account.

Looking at our example of a trader holding a £100,000 contract for £10,000, if the minimum margin requirement (also called maintenance margin) was £8,000, then that means that if the margin balance settles below £8,000 on any day, the trader will get a margin call. This requires the trader to add cash to his margin account to bring it back to the original opening margin amount, or £10,000. So if on one day, the account settled at $7,200, he would be required to immediately deposit £2800, sell his contract, or risk the broker selling his contract to settle the margin call. In futures contracts, both the seller and buyer must have a margin account in good standing. That means that even if you are selling a contract, you must put an initial margin amount in your account and must add maintenance margin when necessary.

Commodities Risks

One of the most appealing aspects of commodity trading is the relative ease with which a trader can buy commodities futures contracts on margin. Unfortunately, this is also one of the biggest risks. Some investors fail to appreciate the fact that when purchasing on margin, it is easy to lose more than your initial investment.

If you purchase a £1000 worth of ABC stock in a cash account and the stock suddenly drops 30%, you have lost £300. However, if you purchased a futures contract on margin, putting up £1000 to control even £5000, then if the commodity price dropped 30%, you have lost £1500, even after only putting up £1000 initially. Even if you liquidate the contract immediately for £3500, you must make up the difference (plus interest in some cases). Imagine this situation with a very large contract. The results could be devastating.

Additionally, just because you want to sell your contract does not mean that someone else will purchase it. This will depend on the liquidity of the commodity. If at a given time there are many sellers and fewer buyers, this may drive down the price of the commodity even further. Futures contracts are a zero sum investment, meaning that there is one buyer and one seller for each contract and as the seller gains, the buyer loses and vice versa.

Margin investors should also be aware that when they are facing a margin call, their broker may sell assets from their account without permission. They will give the trader the opportunity to fulfil the call, but if they fail to do so, they have the right to liquidate other positions in order to meet the margin requirements. The account also becomes restricted, which means that the investor may make no further purchases on margin until the account is again in good standing.

Reason to Purchase Commodities

With all of the risks of purchasing commodities futures contracts, some may wonder why anyone trades them in the first place. The truth is most people should not be trading futures. The average investor does not have the knowledge and skills required to consistently make money trading futures. However, it is also easy to see that successfully trading futures contracts can be very lucrative. Just as we showed above that an account can easily lose more than their initial investment trading on margin can show exponential gains as well.

For instance, using the same numbers as above but with an opposite trend will show quickly how margin accounts can multiply gains very quickly. A security purchased with £1000 in a cash account that gains 30% will earn £300. Meanwhile, a security valued at £5000 purchased with £1000 in a margin account that gains 30% will show profits of £1500. Instead of a 30% gain on the original investment, this is a 150% gain. Of course, this is an extreme example and results such as these are not typical. However, it does illustrate the point that margin account trading for futures contracts on commodities can be very profitable, although quite risky in most cases.