How to Buy Commodities

Commodities are raw materials such as grains, metals, oil and livestock. The exchange of these materials and products has evolved over time from unregulated merchant and supplier contracts, to forward contracts, to commodities derivatives. What this means is the trade of commodities has become increasingly refined with the advent of enhanced logistics, market regulation, massive amounts of product, and electronic means of recoding transactions. There are several ways to participate in the trade of commodities and several key aspects to consider when investing in commodities.

• Commodities are traded as 'futures contracts'
• Futures contracts may be purchased directly or indirectly
• Exchange Traded Funds (ETF's) and Brokers participate in commodities purchases
• Leveraged buying of commodities can increase risk significantly
• Futures commission merchants facilitate the trade of commodities futures
• Several commodities exchanges exist worldwide and in the U.S. are regulated

Indirect exchange of commodities

Indirect exchange of commodities may take place through the buying and/or selling of shares of managed funds that themselves trade in commodities via futures contracts. These funds are called exchange traded funds or ETF's and may have a 1-2% fee associated with the management of the fund.

Through the trade of ETF's, the risk of trading commodities directly can be reduced via (1) knowledgeable management and experience of the fund, (2) diversification of commodities contracts, (3) and indirect involvement in international trade (investopedia.com). ETF's may participate in purchasing of particular commodities or a broad range of commodities.

Additionally, the companies that produce commodities themselves can be traded via mutual funds and/or stocks. These funds and/or stocks are bought and sold through financial institutions that offer brokerage services and offer an alternative to direct exchange of commodities by partial ownership of the commodities producer that's assets include commodities.

Depending on market conditions this type of trade may be more or less risky and garner different yields than direct trade of commodities. Commodities can also be exchanged indirectly through a broker that is licensed in commodities trading. (investopedia.com)

Direct exchange of commodities

Direct exchange of commodities is performed through futures exchanges via futures commission merchants (investopedia.com). Within the United States, these merchants/brokers can be investigated prior to opening an account for registration with regulatory bodies such as the Commodity Futures Trading Commission (CFTC) and the National Futures Association (NFA).

Since many commodities are traded as futures contracts, the actual physical exchange of the commodity does not have to occur as the commodities exchange can resell the physical contract and/or hold the underlying asset value through its market making capacities and/or financial affiliations.

There are several commodities exchanges around the World through which futures commission merchants operate. A few of which include the Chicago Mercantile Exchange (CME) which is now merged with the New York Mercantile Exchange (NYME), Tokyo Commodities Exchange (TOCOM) and Dubai Gold and Commodities Exchange (DGCX) (wikipedia.com) and each day, futures positions are settled and accounts with futures commission merchants are debited or credited to reflect daily changes in the price of futures contracts held. (nfa.futtures.org).

When the trader or broker of the contract decides to sell the contract and/or if the contract expiration date is reached, a final cash settlement will occur yielding either a gain or a loss. Since futures contracts are often bought using leverage i.e. margin that allows the buyer to purchase more with less, large fluctuations in commodities prices can having corresponding multiplied losses or gains to the value of the account through which the contract(s) are purchased.

Summary

Commodities trading involves the exchange of either commodities futures contracts, exchange traded funds (ETF) that themselves trade commodities futures contracts or companies that produce commodities. Levels of risk vary with the method by which commodities are exchanged i.e. direct or indirect, market conditions and the use of leverage in the exchange of shares and/or futures contracts. Commodities futures are exchanged through futures commission merchants who facilitate trade via the commodities exchange itself.

These financial intermediaries function as brokers, charge fees and/or commissions for their services and may be registered with commissions regulatory bodies. The practice of commodities trading may be participated in for a number of purposes including (1) market speculation (2) hedging of risk by commodities producers and (3) financial strategy by funds and/or financial institutions participating in the trade of commodities futures contracts.

Sources:

1. http://www.investopedia.com  (Investopedia)
2. http://en.wikipedia.org/ (Wikipedia)
3. http://www.nfa.futures.org/ (National Futures Association)

Differences Between Futures and Forward Contracts

The difference between a futures contract and a forward contract reveals itself in the way the two contracts are used, how they are regulated, the extent to which each type of contract is utilized, and their influence on financial markets. In fact, there are a number of significant differences between a futures contract and forward contract even though they are related via a historical connection. • Futures contracts evolved out of Forward contracts Futures contracts are a financial instrument that evolved out of forward contracts. Historically, farmers, banking institutions and buyers used to negotiate purchase and delivery of a commodity where the banking institution offered a letter of credit to the supplier based on the purchaser's credibility. In turn the farmer would deliver goods on a specified date and was paid by the banker. The banker then settled with the buyer. Over time commodities exchange process became more sophisticated and the forward contracts themselves were bought and sold without actual delivery of the commodity. Eventually around the middle of the 19th century exchanges emerged in which these contracts were traded in the form of Futures contracts which led to more differences between the two types of contracts. These differences are outlined as follows: • Futures contracts are traded more frequently Futures contracts are more common within financial markets whereas forward contracts are not as vulnerable to price differences caused by frequent exchanges with price differences that reflect changes in market conditions. Additional differences between futures and forward contracts Several specific differences between futures and forward contracts exist. These differences can help distinguish between futures and forward contracts. The following factors illustrate the difference between a futures contract and a forward contract and demonstrate how different these two contracts actually are. • Regulation Forward contracts are not regulated in the same as Futures contracts are. Futures contracts are subject to more oversight from organizations such as the Commodity Futures Trading Commission (CFTC). A history of futures contract regulation can also be found at the CFTC website. • Contract Terms Negotiating a forward contract can be done in a restaurant, at a golf game or at a business meeting. Futures contracts are conducted exclusively through a trading exchange such as the Chicago Board of Exchange. • Derivative Commodity While forwards and futures can theoretically trade in anything, in practice Futures are limited to what the exchange incorporates into its trading mechanism. For example, The Chicago Board of Exchange facilitates futures contracts in agricultural, bond futures and metals futures. Forward contracts have more flexibility in what is traded due to the fact they do not have to be traded through an exchange. • Fees and/or Commission Futures contracts usually involve some kind of fee and/or commission whereas forward contracts between individuals do not have to incur finance charges. • Trading Process Futures are bought and sold in high volumes that would be impractical for forward contracts with delivery. These high volumes are rapidly facilitated through real time exchanges whereas forward contracts can be bought and sold at a coffee shop or business meeting after hours of negotiation. • Insurance The exchange of futures contracts is not always insured whereas the commodities in a forward contract are more likely to be insured. • Contractors and Contractees Since forward contracts have more flexibility, they are more likely to be entered into by a wider variety of contractors and contractees. Futures contracts on the other hand are traded in a more exclusive manner. For example, food distributors and retailers have forward contract when negotiating the future delivery of watermelons for a specified wholesale price, whereas commodities brokers are more likely to buy and sell derivative contracts such as those involving the exchange of oil. Source: http://www.cftc.gov (Commodities and Futures Trading Commission)

Understanding Futures' Tick Size and Tick Volume

Understanding a futures contract's tick size and tick value is essential in the trading of futures financial instruments. These financial instruments are a type of contract that lock in to prices in the present and are either sold or bought at that price in the future. Commodities and currency are often traded in the futures markets such as the Chicago Board Options Exchange (CBOE) and the Chicago Mercantile Exchange (CME)

Tick size is a metric used in futures exchanges and trading that accounts for the smallest unit measure by which the price of a financial instrument can move up or down. Not all financial instruments have the same tick sizes and even those that are similar i.e. Treasury securities, tick sizes vary.

To illustrate tick size further, according to the Chicago Mercantile Exchange (CME), the tick size for a 30 year U.S. Treasury Bond Future is 1/2 of 1/32 of a point. This means each basis point is comprised of individual ticks of .015625. If 100 basis points is one percent, then the tick size is 1/64th of a basis point which is between 1/100th and 2/100ths of a percent, or more accurately .00015625

Tick value represents cost or profit in proportion to the tick size. In other words, a move in tick size will have differing advantages and disadvantages depending on how much money one has invested. Since tick sizes can be so small, very large amounts of money or quantity are needed to influence price movement significantly enough to be worth while.

For example, suppose Mrs. Smith wants to take part in a foreign exchange option. She chooses a currency pair and an exchange rate with which to sell at at a future date. The currency pair is the U.S. Dollar against the Japanese Yen and the exchange rate is 81.3400, meaning one dollar can be purchased with .8134 Yen indicating the Yen is a stronger currency. Now suppose the value of the dollar rises against the Yen i.e. one dollar buys more Yen buy 1 uptick, which is 1/100th of a cent, how much does Mrs. Smith make or lose?

To answer this question we need to understand the futures tick size and value in addition to the amount invested and the strike price. If Mrs. Smith buys $100,000 Dollars with the right to sell at an exchange rate with the Yen at 81.34 within 60 days and the value of the dollar against the Yen increases by ten upticks to ¥81.44, then the value of the Yen has risen by 10,000 which after conversion to dollars at the new rate would be $8,144. In light of this not exercising the option and forgoing the option premium is a wiser choice.

Since futures markets are often highly leveraged to take advantage of relatively small tick movements the risk can be quite high. This is why understanding exactly what a futures tick size and value are is crucial because one small miscalculation could end up costing thousands of dollars if one is overly leveraged and/or a large tick movement occurs.

Sources:

1. http://bit.ly/cPXRPG (Chicago Mercantile Exchange)
2. http://yhoo.it/37rUpV (Yahoo Currency Exchange Convertor)
3. http://bit.ly/bwNEzH (Commodity Futures Trading Commission)

The ABCs of commodity futures

If you want to trade in the futures market there are a few things that might be helpful to know beforehand. For starters, you'll need some money in advance and sometimes a good credit rating to secure certain types of account needed for the commodity futures trading. Also, some knowledge of what it is you're investing in could be advisable as this may reduce your commodity futures trading risk.

• What are Commodity Futures: Commodity futures are financial contracts derived from a particular physical commodity such as corn or copper. These financial instruments are regulated by the Commodity Futures Trading Commission (CFTC) and are often traded back and forth without delivery and/or transfer of a commodity.

• How they work: Commodity futures are traded on special exchanges such as the Chicago Board of Trade. A buyer of futures contracts often purchases on credit meaning they only have to put down a certain fraction of money to buy the whole contract. As the price of commodities changes from day to day, the value of the futures contract also fluctuates in terms of what the underlying commodity is actually worth in relation to the contract.

• How to analyze them: To analyze the value of a future's contract it can be a good idea to investigate the supply and demand of the underlying commodity being traded, broader economic conditions, daily, monthly and yearly price fluctuations and conditions affecting the particular industry. For example, if a hurricane is about to hit the Gulf of Mexico this could positively affect the price of oil futures.

• Benefits of Commodity Futures: Futures trading can be exciting and rewarding. The benefits of futures contracts can be great if the price of a commodity rises after the contract is purchased for a lower price. For example, suppose used cars are a commodity. Person A goes to dealership B to buy 10 used cars 1 month in the future for a special deal price of $15,000. After signing the contract a reputable antique automobile association declares the cars special antiques thereby increasing the market price of those cars and benefiting the buyer of the contract.

• Risks: Inversely, had those automobiles been deemed junk, the value of the cars could drop below the contract price. The contract holder is then obligated to buy the cars at a price above what they are actually worth meaning the resale value of the contract is lower. Since the contract is often bought on credit, the cash deposit a contract holder has can decline faster than had the contract been bought dollar for dollar.

Tips to consider when trading commodity futures

Commodity futures trading is more sophisticated than straight equity trading because it involves derivative calculations, and a more complex set of relationships between the industry and the financial instrument. For this reason it can be considered a good idea to study the calculations required before hand and to plot derivative calculations upon actual commodities price movement to see where one would have been had one acted upon those calculations.

When buying and selling commodity futures, a few suggestions may prove helpful. Specifically, they are as follows:

• Margin Account: Only invest what you can afford to lose as the risk associated with futures trading are greater than straight equity trading and some other forms of investment.

• Commodity: Choose the commodity you know the best as this may assist you in predicting future prices better. Consider things like regulation of the commodity, imports and exports, and seasonality.

• Brokerage: When trading commodities futures a brokerage account is often used. Selecting a broker that his trustworthy, and reputable that provides a wide array of services and investment opportunities for an affordable commission price.

• Analyze: Pre-analysis of a particular commodity using financial tools, mathematical metrics, economic forecasting and market analysis can all assist in making more accurate assessments of the strength or weakness in a particular commodity investment. In turn, these types of analysis may help one be a better investor.

Trading commodity futures can be considered an advanced form of investing. The practice involves some important mathematical calculations and an understanding of the derivative markets and nature of commodities futures is quite important.

The better one knows the market, the trading process and the industry dynamics of the underlying commodity the more possible it becomes to trade successfully. While nothing is guaranteed in investing, it can be helpful to be as well informed as possible before investing. By utilizing the information and techniques illustrated above, one may be better prepared for commodities futures investing.