What is commodity trading?
Commodity futures markets allow commercial producers and consumers to offset the risk of future adverse movements in the prices of the commodities they buy or sell.
In order to work, a future contract must be standardized. They must be of a standard size and degree, expire on a certain date, and have a preset tick size. For example, corn futures trading on the Chicago Board of Trade is 5,000 bushels with a minimum mark size of 1/4 cent/bushel ($12.50/contract).
A farmer may have a field of corn, and to hedge against the possibility of corn prices falling before harvest, he might sell corn futures. He has locked in the current price, if corn prices drop, he makes a profit on futures contracts to offset the loss of actual corn. On the other hand, a consumer like Kellogg can buy corn futures to hedge against a rise in the cost of corn.
In order to facilitate a liquid market so that producers and consumers can freely buy and sell contracts, exchanges encourage speculators. The goal of speculators is to make a profit by taking the risk of price fluctuations that commercial users do not want. The rewards for speculators can be very large precisely because there is a substantial risk of loss.
Advantages of commodity trading
Leverage. Commodity futures trade on margin, which means that in order to take a position only a fraction of the total value must be available in cash in the trading account.
Commission costs. It is much cheaper to buy/sell a futures contract than it is to buy/sell the underlying instrument. For example, a full-size S&P500 contract is currently worth over $250,000 and could be bought/sold for as little as $20. The expense of buying/selling $250,000 could be $2,500+.
Liquidity. The involvement of speculators means that the futures contracts are reasonably liquid. However, liquidity depends on the actual contract being traded. Electronically traded contracts, such as e-minis, tend to be the most liquid, while pit-traded commodities, such as corn, orange juice, etc., are not as readily available to the retail trader and are more expensive to negotiate in terms of commission and spread.
Ability to go short. Futures contracts can be sold as easily as they can be bought, allowing a speculator to profit from both falling and rising markets. There is no ‘rise rule’, for example, as there is with stocks.
No ‘decay time’. Options suffer from time decay because the closer they get to expiration, the less time there is for the option to go into the money. Commodity futures are not affected by this as they do not anticipate a particular strike price at expiration.
Commodity Trading Disadvantages
Leverage. It can be a double edged sword. Low margin requirements can encourage poor money management, leading to excessive risk taking. Not only profits but also losses increase!
Trading speed. Traditionally, commodities are traded in the pits, and to trade, a speculator would need to contact a broker by phone to place the order, who then relays that order to the pit for execution. Once the operation is complete, the pit operator informs the racer, who then informs the customer of him. This can take some time and the risk of slippage can be high. Online futures trading can help reduce this time by providing the customer with a direct link to an electronic exchange.
You may find a corn truck on your doorstep! In reality, most futures contracts are non-deliverable and are cash-settled at expiration. However, some, like corn, can be delivered, although you will get plenty of warnings and a chance to close a position before the truck shows up.