How To Get Started Trading Commodities
As a beginning investor you might already have some familiarity with mutual funds, stocks, ETF’s and even options. Most online brokers have services that allow you to trade a combination of those assets and you understand how to put basic combinations together as part of your investment strategy.
But trying your hand in the commodities market is a different story.
Commodities trade on the futures market – a market that obeys rules that are very different from the one’s you might be used to with stocks and options. You’ll also need to find a broker that allows futures trading. Because of the complexities involved, many online brokers won’t deal with futures contracts so doing your homework before opening an account is critical.
Playing the futures market
A basic futures contract is simply an agreement to buy or sell an asset on a future date for a predetermined price. Let’s use a hypothetical situation as an example of how this works:
XYZ Copper Mining is a company that wants to make sure the price of copper doesn’t go down in the future. The company might agree to sell copper 3 months out at today’s price. If in 3 months the price of copper drops, the company won’t be affected by the loss since they already agreed to sell at a higher price.
While much of the commodities market is made up of hedge contracts like the above example, other traders act as speculators betting on whether prices will rise or fall in the future. Commodity investing could be a way of managing overall portfolio risk while others may simply be placing a bet on prices in the hopes of quick gains.
Technically, futures contracts are for the physical delivery of a commodity. While investors can choose to deal with just the contracts, its important to note that delivery and storage costs are all part of the equation when determining where prices will go.
Futures contracts come with far more risk than trading stocks or options though. While margin accounts may allow you to leverage your portfolio to a degree, futures contracts are designed with leverage in mind. Contracts are leveraged at 10:1, 20:1 or even 200:1 ratio depending on the underlying asset involved.
With leverage so high a small percentage change can result in huge gains or losses. A 5% loss in the contract may be the equivalent of a 50% loss on your investment. Volatility this high means that you won’t be able to hold positions for a long time. Even if you end up being right about price in the long term, even a few days of volatility could cost you your entire investment.
Opening up an account to trade futures isn’t the only way to invest in commodities. Mutual funds and ETF’s that trade only commodities are another option as are companies that rely heavily on commodities such as mining companies. While these types of investments might not be “pure plays” on a commodity, they’re far less risky and could be the right move if the idea of losing your entire investment in one day is unacceptable.