Commodity Futures Risk and Reward
Small Margins and Leverage Mean Large Trading Profits and Losses
Futures trading is lucrative for speculators who correctly predict commodity price movement. It is ruinous when volatile futures prices move against a leveraged position.
A Small Margin Controls a Large Futures Contract
Futures-traded commodity contracts are highly leveraged financial instruments. Traders can enjoy large profits with a relatively small investment called margin. As with real estate, where a modest down payment can control a property whose value is many times greater, margin enables traders to manage a futures position with much more inherent value. A gold contract worth $75,000 can be traded with an initial margin of about $3,500, an $85,000 crude oil contract with only $4,050, an $18,000 corn contract for only $1,080.
Commodity Futures Are Highly Leveraged and Volatile
Compared to real estate (and investments like stocks or bonds) commodity futures are highly volatile. Commodity prices sometimes double or halve in mere weeks. Traders on the right side of the market—with long positions when futures prices rise, or short positions when prices fall—profit, often quickly and handsomely. But the reverse is equally possible: those on the wrong side of the market—with long positions when prices fall, or short positions when prices rise—suffer losses, often significant. Occasionally, in unusually volatile locked or limit markets, traders temporarily are barred from exiting their positions, during which time profits soar, or losses mount.
The arithmetic of leverage is seductive: with a small “down payment” (margin) a trader can reap a huge profit. For example, when gold rose $100 per ounce between August and October, 2007, a trader long the commodity would have profited $10,000 per contract in two months. However, a speculator short gold would have lost exactly as much.
Technical vs Fundamental (Position) Traders
Experienced players in most financial markets, including futures, tend to be either fundamental (a.k.a. position) or technical traders. The former study macroeconomic events and forces, called fundamentals, like supply and demand, war, politics, weather, currency fluctuations, legislation, legal issues, consumer trends, interest rates and fiscal policy. Position traders digest this information and somewhat intuitively take, maintain and exit positions based on their assessment. Position traders tend to stay in the market longer, and ride its inevitable ups and downs, until their objective, codified in a trading plan, is accomplished.
Technical traders pay less, if any attention to fundamentals, and instead analyze price action—what the market has done in the last minute, hour, day, week, month. Theirs is a largely mathematical approach, and involves sophisticated charts, formulas and predictive systems, and possesses a language all its own: momentum, volume, relative strength, moving average, convergence-divergence, regression, Bollinger bands, and many more indicators of price movement, volatility, trends, market entry and exit points and so forth. Technical traders tend to have shorter time horizons, and exit their positions faster, than position traders.
Characteristics of Successful Futures Traders
Besides money (even skilled traders rarely speculate with less than $10,000 in funds they'll never, ever need), those who prevail possess the courage of their convictions, discipline, focus, financial staying power, nerve, determination, patience, confidence, and plenty of plain old hard work. Most winning speculators are exceptionally bright and knowledgeable about the markets and the various forces that influence them. Beyond that, traders who come out on top tend know who they are, and can honestly appraise their tolerance to risk.
How Does One Begin Trading Futures?
First, read, learn and understand. A thorough knowledge of the various commodities, markets, their dynamics, and the mechanics of trading, are requisites. One would be ill advised to delve into the world of commodity futures trading without studying for many months, perhaps even years. Futures trading is definitely not for amateurs.
Many novices first practice by paper trading, an exercise where one takes pretend positions and monitors his or her losses and gains upon simulated exits. Paper trading, however, has no financial consequences, and can never duplicate the real life risk investment of one’s own capital in the futures market.
Finally, enter the futures arena with a strong work ethic. Seldom does one prevail in these markets without the same constant and consistent dedication of highly motivated fellow traders.
