How to trade commodity futures
Hey there, Protraders!
Protrader trading terminal provides access to the trading with various instruments, not only with equities and currencies, but also with commodity futures. Many private traders probably heard about the futures, somebody even trades with it. Therefore, in the current article we’ll try to systematize terms with practical examples, consider the distinctive peculiarities of the commodity futures trading from the equities trading to the trading on the Forex market.
What is a futures?
At first, let’s consider the notion of a futures contract, and what it represents. Futures contract – is a contract to buy/sell an asset at a predefined price, after a certain period of time. This type of contract is binding to execute (either deliverable, i.e. physically, or cash, i.e. cash mutual settlement). The principle of work with futures trades is the same as when trading with currency pairs or equities, with one exception – a limited term of the opened position. For example, buying March futures on the euro, you cannot keep the position opened during half a year, since this contract will exist till 17th of March. If you need to keep the position further, then it is necessary to simultaneously close the position at the current contract and open on far more by duration. “Symbol info” tab in the Protrader provides the detailed information about futures instruments, in particular contract expiration date (contract period), margin requirements from the stock exchange, as well as the type of delivery. Typically, 95-97% of the trades on the exchange end with cash mutual settlement rather than physical delivery.
This example represents financial futures, which also includes indices (S&P 500, Dow Jones and Russell) and bonds.
Commodity futures include:
- Energetics – various grades of oil (WTI, Brent), natural gas, fuel oil, gasoline, ethanol;
- Agricultural commodities – grain, cattle, dairy products;
- Metals – precious (gold, silver, platinum) and industrial (copper, zinc, tin);
- Goods of the “softs” group – cotton, sugar, coffee, cocoa, orange juice.
Participants of the commodity market
Trading of these assets is managed on the commodity exchanges, where products that meet the established standard of the exchange are admitted. Such control ensures proper quality and quantity of the goods for one futures contract.
The main purpose of the commodity exchange creation is to reunite producers and consumers, as well as to protect producers and consumers from excessive price fluctuations (hedging). Exactly, using futures, manufacturers can fix their price that is favorable to them. For example, the cacao manufacturer wants to fix the price for his future harvest, since in the case of oversupply in the market, the prices can strongly fall. On the other hand, the chocolate manufacturer (buyer) has a number of advantages:
- Can plan his own production costs in advance;
- In the case of low demand in the market, he will be protected from the price increase.
These market participants are related to the group of hedgers, since they reduce their trading to the minimization of the price risk. This group is most aware of the processes, and knows the market dynamics better than the other participants.
Apart from hedgers, there are also speculators in the market who try their best to profit from price movements, taking on a much greater risk. This category includes large (banks, hedge-funds, institutional investors) and small speculators.
Another category of the participants – are arbitrageurs, which include banks, hedge-funds, private investors. They make a profit by trading intermarket and calendar spreads.
Peculiarities of the commodity market
There is a large amount of the commodity exchanges in the world, while some of them can be highly specialized exchanges, for example, London Metal Exchange (LME), or exchanges with a wide range of products, such as, Chicago Mercantile Exchange (CME). It should be noted, that one and the same product can be quoted on the different exchanges, and if there is a slight delay in the transmission of quotes, then HFT traders ( high frequency trading) will be able to earn some money on it. Therefore, exchanges try maximum simultaneously to reflect the prices of the same goods.
Commodity futures have several advantages over equities and forex market:
1. Limitations of the price fluctuations. For a private investor or speculator an important point is Daily hard limits. Every day the exchange sets the limitations of the price stroke in the form of levels, and in the case of achieving these levels trading is ceased (in this day). This is done in order to prevent a collapse in prices (or a sharp speculative increase), i.e. considerable speculations on the commodity. Another practice affects the financial futures (indices, currencies and bonds): while achieving the level of limitations, the trading is suspended for a specified time in the specifications. Then the levels are again expanded and trading is continued. Particularly striking example is Swiss Franc!
I hasten to note that these levels are most conveniently used with the options for the relevant underlier. But it is extremely important to know the conditions.
Futures price on the Soybean meal reached “daily hard limit” which means the inability of the further stroke of the price. Sale of the nearest option “out of the money” with strike 435 and premium of $90 was made. This position was absolutely a win-win, because that day was the expiration of these options. Margin requirements intraday for the options are small enough, therefore the volume of sales was very high, which allowed to earn about 6% to the deposit. Unfortunately, such opportunities are extremely rare, but if they appear, they should certainly be used.
2. The seasonal factor. Commodity futures, unlike other markets, maximally follow the seasonal trend. The reason is that the producers perform from year to year the same production cycle.
For example, the largest coffee producers are located in the southern hemisphere (Brazil, Colombia and others) and the maturation of the crop takes place in winter, i.e. in the period of maximum risk and uncertainty for the future harvest. Collecting of the coffee harvest takes place in late May, so the movement of the asset in this period is characterized by lower prices, since market participants have already understood the quality and quantity of the crop.
Seasonality can be also observed on the financial futures, as well as on the currencies, due to the fiscal policy (taxes, transfers, etc.).
Many have probably heard "Sell in May", but it's not just a coincidence, but a particular movement factor. This is due to the deadline for the payment of taxes in the United States, so many market participants transfer their income into the dollars (i.e. close their positions), that puts pressure on the euro. But it should be borne in mind that the seasonality does not talk about exactly repeated patterns of behavior, so it is important to take into account the current market conditions (news, expectations).
3. Fundamental analysis. Professional fundamental analysis of the equities and currencies is a very difficult activity, but the analysis of the commodity market assets is also complicated. Certainly, in the open access there is a data on supply and demand, asset holdings, and data on the commodity turnover (import/export). But in order not to be engaged in "guessing" and follow the factors of influence on the price, it is necessary to penetrate deeply into the causal relationships between price and fundamental data, up to the construction of models, which can include N-number of factors, etc. This can be analysis of the effect of moisture on the future productivity of agricultural products, analysis of global supply and demand, the impact of the currency exchange rate on exports and imports. Combining these factors together gives a complete picture of a particular market. Therefore, many professional traders start to specialize either on one sector or on the 2-3 instruments.
The effect of temperature/humidity mode during crop ripening is very important. In the case of the dry period, the price of the asset may rise sharply, as market participants expect a decline in production volume. A striking example was in the grain market in the summer of 2012, when the lack of moisture and elevated temperature pushed the price of whole grain sector up to new highs.
4. Regulators. Equities market and futures market have a big plus over the Forex and CFD – these are regulators and supervisors. Their main task is to monitor the activities of brokers and major players in order to avoid financial frauds. These committees include: the National Futures Association (NFA), the Commission Commodity Futures Trading (CFTC), and others.
A private investor should know his broker, by whom broker is regulated and which official licenses he has. The great advantage for the client will be the registration of broker in NFA. It is better when the broker has the status of FCM (Futures Commission Merchant or Futures commission trader), and in the cases of misconduct on the part of the broker, the client can write a formal complaint, for example, in the NFA. This organization will certainly react, and if the fault of the broker is proved, then penalty cannot be avoided.
For the record: all FCM brokers are intermediaries between the client and exchange, they do not engage in "drawing" of quotes, do not trade against the client.
As shown by the data from the CME exchange, volume of the traded futures contracts increases every year by 10-20%, making this market the most popular and most liquid in the world.