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)

How futures are traded

To better understand how futures are traded, it is helpful to know what a future is, the history behind them, and the benefits of trading them in addition to the trading process. A 'future' is an evolved financial contract to buy or sell an underlying commodity or product at a future time. Futures are exchanged through authorized clearinghouses such as the Chicago Board of Trade and must be exercised on a predetermined date called the 'final settlement date'.

The exchange of futures contracts is regulated by the Commodity Futures Trading Commission and requires the use of credit to the contract purchaser and has less risk than a similar contract called a forward. Since futures contracts and prices are derived from a product or commodity they all called derivative securities. Speculators often buy and sell these contracts with the intent of making a profit off price fluctuations before the delivery date, however they are also used to by farmers and agriculturalists to hedge farm operating costs, and product sale prices such as those associated with animal feed and grain prices.

The history of futures

Modern day futures trading evolved out of a forward trading system which was used in the mid 1800's as a way for farmers, bankers and merchants to collaborate their interests financially. A forward contract is an agreement between two or more parties to deliver a specific product on a specific date in the future. These contracts are different from futures in that they don't have to be traded using an exchange and the settlement of price is determined by delivery of the product rather than the final settlement date.

One of the largest exchanges through which this process took place was the Chicago Board of Trade, which was called The Board of Trade of the City of Chicago in the 1840's. Over the following 30 years after 1840, futures trading which occurred through the exchanges became more regulated and standardized allowing the futures exchange to become more reliable and standardized. Eventually, in the 1970's a fixed market related to, but separate from the actual underlying commodities emerged in which financial instruments such as bonds and foreign currency could also be traded using futures contracts.

The trading process

Futures are traded using 'margin' which is a financial term for a credit account with a minimum down-payment or collateral. This margin amount is usually between 5-15% but may go much higher. A speculator or trader buys a futures contract through an exchange and/or a broker who works through the exchange and does so at a fixed cost of the underlying security. If the price of the underlying commodity or financial instrument rises during the term of the futures contract, the contract holder can make a profit.

Despite this, if the price falls, a loss will be incurred. During each day the buyer of the futures contract continues to hold it, the profit or loss is recalculated. Speculators in futures trading sometimes use a trading strategy using technical indicators and other financial tools to aid them in their decision making. A step by step process of trading futures is as follows:

1. Use a reliable brokerage account that works through an exchange that trades futures.
2. Choose a commodity or financial instrument to trade in such as coffee or currency.
3. Study the different contracts, the costs and goods.
4. Develop a trading strategy
5. Purchase the Futures contract and hope steps 1-4 work.

Why Futures are Useful

Futures contracts are useful because their derivative nature affords them the ability to represent advanced securities transactions, products and financial instruments through a systematized trading environment. In other words, they greatly facilitate commercial trade. Some of the ways they do this are as follows:

• Control price risk fluctuations by locking into a fixed price
• Assist companies in generating capital in advance of sale.
• Demonstrate buyer and seller predictions of future prices.
• Assists observers with assessing economic and market conditions through price efficiency theory.
• Can be used across many markets including currency, bond, equity index and commodities markets.

Who Invests in Futures and Why

Futures are traded by farmers, agriculturalists, financial institutions and speculators. While all have a financial interest in the contract, they may have different reasons for entering into the contract. In the case of 'hedging' for risk , farm managers and crop farmers attempt to bring a more stable cost and selling environment to their operations through locking into a futures contract price they think is fair. For speculators and financial institutions however, the purpose of the contract is different. For these latter two participants, the intent is profit. These latter two generally do not intend to exchange the underlying commodities but rather the money for them and hopefully at a profit. Since the clearinghouse assumes the cost of the commodities they take responsibility for the cost of the commodities and can re-sell the contract.

Summary

Futures contracts are financial agreements to buy or sell an underlying commodity at a fixed price on a settlement date. While the actual commodity need not be exchanged, this does happen as the futures market has evolved out of an actual commodities exchange system. The currently futures market is currently very sophisticated, and takes place through traditional trading and electronic exchanges that are regulated by Commodity Futures Trading Commission (CFTC). 

Futures contracts have the potential to be costly especially if the price of the commodity drops rapidly within a short time period. However, the contract may also be profitable if exercised at a profit. Futures contracts have a history in the commodities trade of farm products but have expanded to include metals, energy resources and financial instruments such as currency and bonds.

Sources:

1. Zvi Bodie, Alex Kane and Alan J. Marcus. 'Investments' New York. 2002 McGraw-Hill Irwin. p.739-760.
2. http://www.answers.com/topic/futures-contract?cat=biz-fin
3. http://eh.net/encyclopedia/article/Santos.futures
4. http://www.riskglossary.com/link/future.htm
5. http://en.wikipedia.org/wiki/Futures_contract
6. http://www.cftc.gov/

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.