Futures Trading Is An Extremely Risky Business

The reason traders are called speculators is because of the risk involved.

The "truthful" successful traders will all tell you the same thing. It takes time, patience and experience to become a successful commodity trader. Patience is something you will have to dig down deep within yourself to get.


Be wary of the claims that you can make your fortune overnight trading commodities with little or no risk.
Anytime someone feeds you that sort of hype they are more then likely selling a 'can't lose trading course'. or a 'sure fire no risk trading system'.. Grab your hat and run for the nearest exit if anybody claims they can predict exactly what commodity prices will do.

The only "EXACT" thing that ever happens when trading futures is that the broker gets paid.

What Are Commodities.

Commodities are what make up the things we use every day. Grains that make the corn flakes and bread we eat to cattle that contribute the steaks we throw on the barbecue in the summer. Also included as commodities are Gold, Silver, Foreign Currencies and U.S. Treasury bonds to name a few.

Commodities are traded as contracts and have a definite expiration date, unlike stocks that can be around forever, unless of course the company goes belly up like a large number of the Dot Com companies did in the past year or so.

The actual physical commodity does not exchange hands when traded on the commodity exchange. It would not be a pretty sight seeing 40,000 pounds of live hogs roaming around the trading floors in Chicago. Instead what happens is buyers and sellers from around the world trade paper in the form of a legally binding contract for a specified product of a specified quantity and quality for a specified time.

Commodity contracts expire.

It is Very important that you remember that last statement.

If the speculator decides to take delivery of the product at the expiration of the contract they are given a receipt indicating where the product is stored or how they can take delivery. I'll bet you thought you'd have a thousand bushels of corn delivered to your garage.

In the case of 'Cash Settlement', as is the case for currencies and bonds, money transfer instructions are issued. In the normal course of a transaction very few contracts are held to expiration. The traders will offset their position by either buying or selling back the contracts.

Who are the Commodity Traders?

There are two groups of people that make use commodity markets. The main group is called 'Hedgers'. They are:

The producers like farmers and cattle ranchers that will either buy or sell futures contracts against their physical products to be assured of a profit. The physical products being a corn or wheat crop.

Also in this group are the end users. Companies like Kellogg 'tm', Maxwell House Coffee 'tm', Hershey 'tm', and the big meat packing companies need the products for their business. They will buy or sell futures contracts to know what their cost for material will be at a given time in the future.

To illustrate how a farmer might use the commodity market as a hedge. A farmer has estimated that it will cost $2.00 to grow a bushel of corn and he wants 20% profit at harvest time. Therefore, the farmer needs $2.40 a bushel. If the current cash price for corn is $2.40 he could sell one or more contracts of corn for delivery in December for $2.40 / bushel.

One standard contract of corn = 5000 bushels. $2.40 x 5000 = $12,000. Rarely will they sell contracts against their entire crop because the crop yield is unknown.

Follow this scenario. The price of corn at harvest has dropped to$2.20 a bushel. (Remember the farmer needs $2.40 p/ bushel.)

First, the farmer sells his crop for $2.20 a bushel. Second, the farmer buys back the futures contracts for $2.20 for a gain or 20 cents. The math works out like this:

Sold Futures Contract $2.40 p/bu
Offsets Position (Bought Back) $2.20 Gain $0.20
Sells corn crop to grain elevator $2.20
Total proceeds form crops and 'Hedge' $2.40 ($2.20 + .20)

The farmer gets the price he/she needed by using the commodity markets as a hedge against lower crop prices to realize a 20% profit.

Here is how it would have worked out had corn prices increased. For our example let's say corn prices increased to $2.55 at harvest. Great news for the farmer. Right? Not necessarily. The farmer gave up future profit to be assured of a known profit at harvest time

Sold futures contract (Hedge) $2.40
Offset position (Bought back contracts) $2.55 Loss -$0.15
Sells corn crop to grain elevator $2.55 p/bu
Total proceeds from crops and 'Hedge' $2.40 ($2.55 - .15)

As you can see the farmer still realizes a crop price of $2.40. It's actually a little more complicated than that but it should give you some idea of how the commodity markets work for producers. The end users use the hedge in much the same way.

The other players in the commodities markets are the speculators.

The large speculators.

These are mainly the large commodity pools, similar to a stock market mutual fund. The pool managers will buy and sell large numbers of commodity contracts in an effort to make a profit for their investors.

The small speculators, that's us.

We buy and sell futures contracts based on fundamental and technical analysis of a market trying to determine where a particular market price will be at some point in the future.

Speculators Provide Liquidity.

The farmer wants the highest price possible and the giants like the breakfast cereal makers want the lowest price possible. The Hedgers are in the market for the long haul, several months to sometimes a year or more. They are in effect putting their risk of future price fluctuations on the open market for someone to assume. Without price movement provided by speculators the hedgers would soon reach an impasse on price.

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Richard Tolar survived a ruptured brain aneurysm six years ago. Up until that time he was a very successful futures trader. He also had some success in the FOREX markets. He wrote a book on how to trade price patterns in both of the fast moving markets. He is passing on his knowledge with this series of articles. Pick up his free ebook "How To Trade Price Patterns In The Futures Markets" at My Futures Blog.