Intermediate Concepts In Commodity Trading
Table of Contents
- Commodity Trading……………………………………..…….…..2
- How Trading is Conducted……………………………..……….3
- Basic Trems Used in Commodity Trading………..…….…3
- Factors Affecting Commodity Trading…………….….……4
- Benefits of Commodity Trading…………………………..….6
- Minimum Lot size of major commodities………………..7
- Risk Management…………………………………………………..7
Welcome to the intermediate eBook for commodity trading. This eBook will help you to learn more about commodity trading and how trading is conducted, as it introduces Factors affecting commodity trading, Benefits, and risk management.
1. COMMODITY TRADING:
Commodity trading is an investment, wherein goods are traded instead of stocks. In this type of trading has many similarities to stock trading, but the biggest difference is the asset that is traded Commodities have very less or negative correlation with other asset classes.
Some of the top traded commodities are crude oil, coffee, natural gas, gold, silver, copper, sugar, corn, wheat, and cotton to name a few.
The complexity and volatility of commodity markets deter people from investing here.
But a well-planned commodity investment can be beneficial for your portfolio.
There are six major commodity exchanges in the U.S.:
|The New York||The Chicago Board of||The Chicago|
|Mercantile Exchange||Trade||Mercantile Exchange|
|The Chicago Board of||The Kansas City||The Minneapolis Grain|
|Options Exchange||Board of Trade||Exchange|
The New York Mercantile Exchange Inc. is the world’s largest physical commodity futures exchange. When the hours of open outcry and electronic trading are combined, some exchanges are open for nearly 22 hours a day.
2. HOW IS TRADING CONDUCTED?
Buyers and sellers can trade a commodity either in the spot market/cash market, whereby the buyer and seller immediately complete their transaction based on current prices, or in the futures market.
If the price of the underlying commodity goes up, the buyer of the futures contract makes money. He gets the product at the lower, agreed-upon price and can now sell it at the today’s higher market price. If the price goes down, the futures seller makes money. He can buy the commodity at today’s lower market price and sell it to the futures buyer at the higher, agreed-upon price.
3. BASIS TERMS USED IN COMMODITY TRADING
Lot size: Usually any definite quantity of a commodity of uniform grade, the standard unit of trading in the futures market.
Margin: Futures margin is a good-faith deposit or an amount of capital one needs to post or deposit to control a futures contract. The margin is a down payment on the full contract value of a futures contract.The margin is set based on the risk of market volatility. When market volatility or price variance moves higher in a futures market margin rates rise.
Open Interest: The total number of futures contracts of a given commodity that have not yet been offset by an opposite futures transaction nor fulfilled by delivery of the commodity or option exercise. Each open transaction has a buyer and a seller, but for calculation of open interest, only one side of the contract is counted.
Offer: An offer is when one party expresses interest in selling a commodity or a contract at a given price. It is the opposite of bid.
Spread: The price difference between two related markets or commodities or between contracts of different maturities of same commodity.
Volatility: A measure of the change in price over a given time period. It is often expressed as a percentage and computed as the annualized standard deviation of percentage change in daily price.
Volume: The number of purchases or sales of a commodity futures contract made during a specified period of time, often the total transactions for one trading day.
4. FACTORS AFFECTING COMMODITY TRADING
Commodities futures accurately assess the price of raw materials because they trade on an open market. They also forecast the value of the commodity into the future.
GOVERMENT ECONOMIC AND
DEMAND AND WEATHER
Inflation: Commodities are measured as hedge opposite inflation because unlike stock, commodity prices go in the direction of the inflation. With the augment in inflation the prices of chief commodities tend to boost and it is very true the other technique as well.
Storage and Transportation factors: All type of commodities has a real physical form and therefore these commodities are stored prior to its distribution. It is not a financial product so inventory cost and storage do not affect such a large impact on the market prices. However, this factor does not affect the prices across all commodity asset classes in the same quantity but it depends on the type of commodity in question.
Economic and political conditions: The prices of commodities are also impacted by the economic and political conditions of the countries that are producing and consuming them. For instance, during the Gulf War in Iraq—which was a major producer of oil—the price of oil fluctuated very frequently. Moreover, weak economic conditions reduce the spending power of consumers, leading to falling in demand, which results in movement in prices.
Weather conditions: A majority of commodities traded in the world markets are agricultural goods, and the production of these goods depends on the weather. Sudden changes in climatic conditions like inadequate rainfall or draughts might affect the availability of agricultural goods in the world market, causing scarcity and pushing commodity prices northwards.
Demand & supply: Demand and supply are key factors that influence the movement of price in the commodity market. The law of demand and supply plays the same role for equity as well as commodity markets. However, demand and supply of all commodities change during different time periods. It depends upon seasons, national and international conditions and many other major factors affect its characteristics.
Government policies: Any changes in the government policy, especially the ones impacting import/export cost to the buyer or seller will have a huge impact on commodity prices. If, for instance, the Indian government increases import duty on edible oil, its price will show a proportionate increase and vice versa.
Extraordinary events: There may be assured extraordinary factors, that do not happen very frequently. Natural calamities, wars, depression, etc. are such as events that affect the commodity prices in a theatrical way.
5. BENEFITS OF COMMODITY TRADING
Diversification: Commodities can diversify a portfolio. Commodity returns usually have low or negative correlations with the returns of other major asset classes. When the price of bonds and stocks fall, commodities rise. Factors that affect returns on stocks and bonds, do not affect returns on commodities in the same manner.
For example, the prices of stocks may fall during a financial crisis. But gold prices may rise as demand for this safe asset increases. A diversified portfolio with a low correlation between its assets tends to have less volatile returns. Thus, investing in commodities ensures diversification and improves risk-adjusted returns.
Inflation protection: Inflation has a different impact on commodities than financial assets like stocks and bonds. This is because high inflation causes the currency to depreciate. This reduces the real value of financial assets like stocks and bonds. Commodities, however, maintain their value and price even during high inflation. As a result, investors can turn to hard assets such as gold and other precious metals.
Hedging: Whenever the rupee becomes less valuable, you need more money to buy commodity goods from different parts of the world. Especially during inflation, the prices of commodity goods go up as other investors sell off their stocks and bonds to invest in commodities. Therefore, you can benefit from some commodities in your portfolio that act as a potential hedge against risks.
Liquidity: Unlike investment in assets like real estate, investment in commodity futures offers high liquidity. It is easy to buy and sell commodity futures. An investor can liquidate his position whenever required.
Trading on Lower Margi: An investor in commodity futures needs to deposit a certain amount as a margin with the broker. The margin can be close to 5 to 10% of the total value of the contract, which is much lower considering other asset classes. Such a low margin allows you to take larger positions at a lesser capital.
High returns: Commodity market is a riskier form of investments with huge swings in prices. For example, the war in a major oil-producing country like Iraq can cause oil prices to shoot up. Smart investors can take advantage of these price swings to make gains. Well-planned commodity investments can provide higher returns than investments in other assets.
6. MINIMUM LOT SIZE OF MAJOR COMMODITIES
|Commodity||Unit||Lot Size||Commodity||Unit||Lot Size|
|Crude Oil||Barrel||1000||Gold||Troy Oz||100|
|Silver||Troy Oz||5000||Natural gas||mmBtu||10000|
|Coffee||lbs (100)||2000||Sugar no. 1||lbs (100)||1120|
|Cotton no. 2||lbs (100)||500||Brent Crude||Barrel||1000|
7. RISK MANAGEMENT
Profiting from commodity trading often requires a combination of market knowledge, and most importantly strong risk management.
Do not risk more than 5 percent on any one trade. Most professional money managers, risk less than 2 percent on any one trade. This is tougher if you start trading commodities with only a $10,000 account. In this case, you should risk no more $500 on a trade. If you want to risk no more than $500 on a trade, all you have to do is place a stop loss order $500 away from your entry. It doesn’t guarantee you won’t lose more than $500, but it is as close as you can get.