Trading Commodity Futures – Here’s What You Need To Know
The commodity futures market is one avenue that can provide you with the opportunity to make a return on your capital in a short period of time.
When you trade in commodity futures, you are essentially entering into a speculative transaction. If you expect that the price of a certain commodity, say oil, will rise in the future, you can enter into a contract that will result in a profit if your reading of the market was correct. Conversely, you will lose money if the market moves in the opposite direction.
You can enter into commodities futures contracts for precious metals like gold, silver, and platinum, or agricultural products like crude palm oil, rubber, and sugar. You can also trade in base metals like copper, aluminium, and tin. Futures contracts are also available for light sweet crude, Brent crude, natural gas, and heating oil.
“Average investors used to have a perception that commodity markets required significant amount of money and expertise in order to participate the markets,” said Nicolas Dupuis, senior director of Energy Products at leading derivatives marketplace CME Group.
“But in fact, there are a number of different ways make it easy for non-professional traders to participate and a popular way to invest in commodities is through a futures contract,” he adds.
Commodity futures contracts are an effective way to diversify your portfolio and make profits in both rising and falling markets. According to the Monetary Authority of Singapore, this activity has seen a sharp increase in volumes in the recent past. The number of commodity futures contracts doubled to 15.7 million in 2016 -17.
Start out with what you know best
A common recommendation for novice traders of any segment, is to start with something they are familiar with. In the commodity futures space, crude oil is the most well-known – given its importance as a major energy source – and is also the most actively traded.
“Commodities like crude oil markets are highly active, providing opportunities in nearly all market conditions. They also can be highly volatile, with prices affected by a number of factors directly related to the industry or occurring on a more macroeconomic level like weather and geopolitical environment,” says Dupuis.
In fact, crude oil is not a homogeneous commodity. There are a large number of different oil benchmarks, representing the different regions from which it is produced. However, most of their prices would be pegged to one of three main benchmarks: Brent Blend, West Texas Intermediate and Dubai/Oman.
The oil contracts available for trading on the futures markets, are, in turn, in accordance to these three benchmarks. Examples include Brent crude oil futures which are traded on the Intercontinental Exchange (ICE) Europe and WTI Light Sweet Crude Oil futures that are traded on the New York Mercantile Exchange (NYMEX).
According to Dupuis, crude oil futures – like the NYMEX WTI futures contracts offered by CME Group – offers a number of advantages that make them “an efficient and flexible tool” for participating in the oil market.
- A deep, liquid market with trades of over 1.1 million contracts daily and over 2 million in open interest, offering the depth to handle orders of any size
- More trading hours – nearly 24-hour, 6 days a week electronic access, allowing traders manage positions around the clock and around the globe, unlike stock markets or ETFs markets
- Greater capital efficiency – leverage of futures allows traders to control a large notional value in oil with a small amount of capital, instead of putting down 100% capital to control stock.
Fundamental analysis and technical analysis
If you are to profit from a trade, you must be able to correctly predict whether the price of the selected commodity will rise or fall. There are two methods of doing this.
Experienced traders often use technical analysis (TA). TA uses price movements over a certain period to predict the future direction that the market will take. A trader using TA would use the patterns in market data to identify trends to predict short term price movements.
For a much broader viewpoint, the quintessential method of analysing a selected commodity is fundamental analysis. This involves keeping track of economic and market developments to identify a commodity’s longer term price trend. Using this information, you would be able to predict the demand and supply position of a commodity more accurately, and enter into a trade based on your estimate of its future price.
Fundamental analysis is also a preferred strategy for new commodity traders who might have difficulty in forecasting short term price movements.
Avoid the most common mistakes
One of the biggest mistakes that traders make is that they delay exiting from a losing trade. If the market is moving in the opposite direction from the one that you had predicted, you should cut your losses. But adopting this policy is difficult. By closing the trade, you will be losing money. Although it is the logical step to take, many traders delay in the hope that the market reverses direction.
On the other hand, if your trade is making money, do not be in a hurry to exit. “Letting your profits run” is a principle of trading. Again, inexperienced traders, or those with inadequate discipline, find this rule hard to follow. They prefer to realise their gains immediately. They fail to see that by doing this, they could be sacrificing the amount they would make if they stayed the course.
“Futures give a fast, cost effective way to trade commodity markets nearly 24 hours a day in a stable and highly regulated environment with deep and liquid markets that let traders express their opinions in a tremendously efficient way,” said Dupuis.