Commodity trading is a business. It started as such, is so now, and will continue to be a business in the future. Back in the mid-1800’s, the McCormick reaper was invented, which greatly enhanced the production of wheat in America. About the same time, Chicago was becoming a major commercial center. Wheat farmers from across the country were coming to Chicago to sell their wheat to the grain dealers, who then sold it to commercial buyers all over the county.
At that time, Chicago had almost no place to store wheat and had poor methods for weighing and grading it. This left the farmer at the mercy of the grain dealers.
In 1848, a central exchange was formed where farmers and dealers could meet to deal in “spot” grain, which is selling wheat for cash and immediate delivery.
Soon after this, farmers and dealers began to deal in “futures contracts.” This simply means that the farmer (seller) would contract with a dealer (buyer), to deliver wheat at a specific date in the future for a pre-determined price. Hence, the name “futures” trading evolved. This worked well for both parties, as the farmer knew in advance how much he was going to be paid in the future, and the buyer knew his future cost beforehand.
These contracts became so common that banks started to take them as collateral for loans. Sometimes the farmer might not want to deliver the wheat, and would sell his contract to another farmer, who would take on the obligation to deliver. Other times the dealer might not want to take delivery, and would sell his contract to someone who wanted to take delivery. Before long, speculators, who saw an opportunity to buy and sell these contracts, hopefully at a profit, came into play. These were the first commodities “traders” as we know them today, and they had no intention of ever taking actual delivery of the wheat. They began trading these contracts among each other, hoping to buy low, and sell high, or sell high, and buy low.
Commodity Trading is a Business Today
If you start to trade thinking that you are going to get rich overnight, you’ll probably lose all that you invest.
Commodity trading is a business like any other, and must be treated like a business. If it is not, you won’t see success. However, if you are diligent in your studies, and have the persistence and fortitude to learn what’s needed, this can greatly contribute to your success as a trader.
Becoming wealthy in the commodities business is not uncommon. Many people have done it before, and many more will do it in the future. Even if you don’t have a lot of money to start trading with, you can still be successful. Richard Dennis, as an example, borrowed $1,600 and turned it into $200 million dollars in about ten years. He didn’t do it overnight and without tremendous effort. He studied, applied himself, and made a plan, and followed his plan exactly.
Millions of dollars have been lost by people who enter the commodities market without sufficient training with the idea of getting rich overnight. When they don’t get rich, and even worse, lose all their money, they blame the commodities market itself. The person they should blame is themselves. This accounts for the negative stigma associated with commodity trading. Many people see it only as a form of gambling. In some ways it is, but we can stack the odds in our favor. If you want to learn to trade properly then check out my Complete Commodities Course.
Trading commodities is different than trading stocks. When you buy a stock, or a piece of real estate, you actually own it. When you buy, or sell, a futures contract, you are speculating on the future direction of the price without ever really owning anything. You simply own the right to buy or sell the commodity, at or before a future delivery date, at a pre-determined price.
As a speculator, this right to own is sold back to the market before delivery obligations are triggered. If you “buy,” then you are considered “long”, and are speculating that prices will rise. If you “sell”, you would be “short”, and speculating the prices will decline. In other words, you are trying to buy low and sell high, or to sell high, and buy low. We will be discussing this in detail later.
There are three positions in trading: long, short, and out. Most of the time the third position is the correct position, but it’s not used often enough.
To understand how you, a speculator, fit into the picture, let’s look at a commodity from start to finish. Now, put your farmer hat on for a minute, and hop on the plane to Wyoming. You’re a wheat farmer now, and you planted your crop about three months ago. In a few months it will be ready to harvest. After careful analysis, you figured out that it cost you about $2.00 a bushel to grow it, including paying for your entire overhead. Anything you can sell it for over $2.00 a bushel is profit for you.
Let’s assume that right now, wheat is selling for $3.00 a bushel, but the price has been going down over the last few weeks. Since it’s going to be three months before your crop is ready for harvest, what can you do to assure yourself a profit on your crop? You are concerned that if the price continues to drop, in three months the price may be lower than $2.00 a bushel, which is what it cost you to grow it. Now what do you do? You sell your future crop by calling a commodities broker and selling a futures contract for $3.00 a bushel to be delivered three months from now, in December, as an example.
Your risk in doing this is that, if the price of wheat goes up to $3.50 a bushel during the next three months, you are going to get only $3.00 a bushel because you pre-sold it today for $3.00 a bushel. But, on the other hand, if the price of wheat drops below $3.00, you have locked in your price of $3.00 a bushel. You feel this is a good way to go, since the price of wheat has been going down, not up, in the last few weeks. This process is called “hedging.” You have probably heard that term before.
When you called your broker to “sell” (also called “going short”) a contract, he acted as a middleman, and helped find someone to “buy” (also called “going long”) your contract. Now who would want to buy your wheat contract at $3.00 a bushel? It could be a large company, like Wonder Bread, who is buying wheat and is concerned that the price of wheat will go up, not down, three months from now, and they want to protect themselves in case of a price increase. Of course it could be a speculator who is looking to make a profit.
So you sold a contract to lock in your profits, the other person bought a contract to guarantee their price, and your broker, acting as a middleman, earned a commission for doing this, and you slept a little better that night.
Let’s change hats again. You fly back home, and put your speculator hat on. You carefully analyze your charts on wheat, and, yes indeed, the price has been dropping, but it looks like the price is going to stop dropping and start to go back up again. You think that in three months, it’s going to be $3.50 a bushel, not $3.00 a bushel that it’s selling for today. (You will learn later how to analyze charts to get a good idea where prices may head.)
You sense an opportunity to be able to buy a contract at today’s price of $3.00 a bushel and sell it a few months later for $3.50 a bushel. If you are correct and the price goes up, you are making a profit on your commodities contract. When you buy the contract at today’s price of $3.00, you are guaranteed that price by the person who sold you the contract. They must honor their end of the agreement, and sell it to you for $3.00 a bushel at the end of the contract, even if the price goes up.
On the other hand, if the price of wheat goes down, you lose money. How would you lose money? If the price of wheat three months from now is $2.50 a bushel and you agreed to buy it for $3.00 a bushel, you have lost 50¢ a bushel, for the total number of bushels in your futures contract, which in the case of wheat is 5,000 bushels.
The major difference between stocks and commodities is leverage. I’ll show you what I mean. A contract in wheat is for 5,000 bushels. You don’t actually buy or sell 5,000 bushels, you just control 5,000 bushels. You would put up a “deposit” with your broker for the right to do this. In the case of wheat, that “deposit” which is also called your “margin,” is only $540. So $540 controls one contract for 5,000 bushels of wheat.
If you had paid all cash rather than buying a futures contract, you would have to spend $3.00 X 5,000 bushels or $15,000. This is the power of leverage. With a futures contract you still control 5,000 bushels, yet you only put up a deposit of $540 to do so. It’s almost a 30-to-1 leverage in wheat.
Let’s look at how much you would have made by paying cash for 5,000 bushels if the price went up.
Bushels purchased 5,000
Current Price x $3.00
Total Cash Paid $15,000
If the price of wheat went up to $3.50 per bushel, you would make 50¢ per bushel, or $2,500 profit (5,000 x 50¢). A 17% return on your investment in just 3 months. Not bad.
Let’s take a look at what your return would be if you had bought a futures contract (went long), rather than paying all cash. Remember the margin, or deposit, on a wheat contract that controls the same 5,000 bushels is just $540. If wheat did in fact go up to $3.50 a bushel and you sold it, you would of course still make 50¢ a bushel, just like you would have if you had paid cash for 5,000 bushels, or the same $2,500. The difference is that you made a 463% return in three months with the futures (because you only put up a deposit of $540) verses a 17% return for cash. That’s what I call leverage! This, by the way, is a huge move in the price of wheat and I used it only as an example.
Anytime you have the potential of making a profit, you also incur the potential of taking a loss. Keep in mind that your potential loss is also leveraged. In the example above, if the price of wheat dropped 50¢, to $2.50, you would have lost $2,500 (50¢ a bushel X 5,000 bushels). Now for the good news! You can in some ways limit your losses. In other words, you can stack the odds in your favor. There are several ways to do this, and you will learn about them as you continue reading and studying how commodity trading is a business.
The Future of Commodity Trading
Many people who trade commodities are average hard-working people, probably a lot like you, who are just trying to supplement their income and trade on a part-time basis. Based on my experience, I’d bet that less than 1% of the speculative traders are full time.
There are basically two types of traders, although some people mix a little of both in their trading style.
The fundamental trader, or a fundamentalist, is someone who studies the supply and demand of a given commodity. They look at things like the weather patterns around the world, droughts or floods for example, that would affect the world’s supply of a commodity like wheat. Remember that commodities are a worldwide market, not just here in the USA. As a fundamentalist, you might buy a wheat contract because you think there is going to be a drought this summer in Russia, causing the price of wheat to go up because the supply will be down.
The technical trader, or a technician, bases his decisions on current and past market trends that are reflected on charts. Let’s say that you are looking at a chart and you see that the price of wheat is the lowest that it’s been in 20 years. Based on that and other technical indicators, you might “go long” on a futures contract in wheat, thinking that the price is going up.
Next, let’s get into the details of technical trading. One of the advantages of being a technical trader is that you don’t have to become an expert in the fundamentals of the underlying commodity. Technical trading is trading based upon technical information found on the charts. Let’s say that you wanted to trade Cocoa. As a technical analyst you don’t have to know anything about where Cocoa comes from, weather conditions, etc. That’s why I like to teach people to trade using technical analysis.
When you are ready to trade, you can open an account with as little as $2,000. Don’t expect to make much with a $2,000 account but you can certainly make a trade or two a month with this size account. I always recommend that you never start with more than $50,000, no matter how much money you have. The reason is, that if you can’t learn to make money with $50,000, then you probably won’t make it with $500,000 either. If you are doing well and want to add to your account later, you can do that, but learn to crawl before you walk, and walk before you run. Take it easy! Learning to trade is a marathon, not a sprint. Also, before investing any real money you must learn to paper-trade. This is how you practice and learn to trade. If you can’t make money “on paper”, you can’t make it with real money either. Also, don’t invest more than you can afford to lose, and assume you will lose it all. If you can’t live with that thought, then don’t trade at all.
You might find this hard to believe but when you first start trading, you’ll probably spend less than 30 minutes a day, maybe an hour, on your trades. If you are trading on a full-time basis, you will spend two or three hours a day, more on some days and less on others. Until you start to paper-trade, you won’t understand just how little time it really takes.
You might be wondering what kind of equipment and supplies you need. How about a telephone, a computer, and some inexpensive software? That’s all you really need.
We’re going to cover the dozens of techniques to interpret charts. Once you learn to do this correctly, you could make a comfortable living in the commodities market. Some may even do much better.
You must learn to limit your risk to a level that is within your own comfort zone. You will be able to use several techniques to do this. Learning to control risk is equally, if not more, important than learning how to make profits.
Knowing when to take profits is a key to making a fortune in this business. If you don’t know when to take profits, you can end up giving back everything you make. Even more important than taking profits is knowing how to control your losses. You also will learn some powerful techniques to do this.
Again, I want to stress that you must first learn to paper-trade. You can practice trading on paper without risking a penny. You can paper-trade for weeks or months if you like. After you feel confident that you know what you are doing, and are consistently making money on paper, then, and only then, should you put real money in the market. Trust me on this, as I speak from experience! I won’t sugarcoat anything and I’ll tell you right now that you can lose your shirt, your pants, your socks and your shoes, and no one but you will care.
Do you want a discount broker or a full-service broker? Do you want to trade online using a software trading platform? What is a fair commission to pay? How do you know if you’ve got a good broker or clearing firm? All of this and more is covered right here.
You’ll also gain a good understanding of how to trade by the time you complete the courses available here. As a matter of fact, I think you’ll know more than many people who have been trading for years!
I hope this article on how commodity trading is a business is just the beginning for you. Every day you trade, you’ll learn a little more. You will also want to read a few good books from time to time.
Learn more about David's Personal Coaching with Common Sense Commodities for leading edge information and training in commodities and options trading.
* Testimonials are not a guarantee of future success. All information is for educational use only and is not investment advice. Trading financial instruments, including Stocks, Futures, Forex or Options on margin, carries a high level of risk and is not suitable for all investors. The high degree of leverage can work against you as well as for you. Before deciding to invest in any of these financial instruments you should carefully consider your investment objectives, level of experience, and risk appetite. Only risk capital should be used for trading and only those with sufficient risk capital should consider trading. The possibility exists that you could sustain losses exceeding your initial investment. You should be aware of all the risks associated with trading and seek advice from an independent financial adviser if you have any doubts. Past performance, whether actual or hypothetical, is not necessarily indicative of future results. All depictions of trades whether by video or image are for illustrative purposes only and not a recommendation to buy or sell any particular financial instrument and do not factor in trading costs in trading examples due to varying commission and fees among traders. The impact on market prices due to seasonal, market cycles or news events may already be reflected in the price. See full risk disclosure. See full risk disclosure.