Commodity Trading: Advantages and Disadvantages
What is commodity trading?
Commodity futures markets allow commercial producers and consumers to offset the risk of future adverse price movements of the commodities they buy or sell.
In order to work a future contract must be standardized. They must be of a standard size and grade, expire on a certain date, and have a preset tick size. For example, corn futures trade on the Chicago Stock Exchange is 5,000 bushels with a minimum tick size of 1/4 cent/bushel ($12.50/contract).
A farmer might have a field of corn, and to hedge against the possibility of falling corn prices before harvest, he might sell corn futures. He has locked in the current price, if corn prices fall, he makes a profit on the futures contracts to make up for the loss on actual corn. On the other hand, a consumer like Kellogg may buy corn futures to hedge against an increase in the cost of corn.
In order to facilitate a liquid market so that producers and consumers can freely buy and sell contracts, exchanges encourage speculators. The goal of speculators is to make a profit by assuming the risk of price fluctuations that trading users do not want. The rewards for speculators can be very large precisely because there is a substantial risk of loss.
Advantages of Commodity Trading
Leverage. Commodity futures operate on margin, which means that to take a position only a fraction of the total value must be available in cash in the trading account.
Commission Costs. It is much cheaper to buy/sell a futures contract than it is to buy/sell the underlying instrument. For example, a full size S&P500 contract is currently worth more than $250,000 and could be bought/sold for as little as $20. The expense of buying/selling $250,000 could be $2,500+.
Liquidity. The involvement of speculators means that futures contracts are reasonably liquid. However, liquidity depends on the actual contract being traded. Electronically traded contracts like e-minis tend to be the most liquid while pit traded commodities like corn, orange juice, etc. are not as readily available to the retail trader and are more Expensive to trade in terms of commission and spread.
Ability to go short. Futures contracts can be sold just as easily as bought, allowing a speculator to profit from rising and falling markets. There is no ‘rise rule’, for example, as there is with stocks.
No ‘decay time’. Options suffer from time decay because the closer they get to expiration, the less time there is for the option to go in-the-money. Commodity futures are not affected by this, as they do not anticipate a particular strike price at expiration.
Disadvantages of Commodity Trading
Leverage. It can be a double-edged sword. Low margin requirements can encourage poor money management, leading to excessive risk-taking. Not only profits but also losses increase!
Trading speed. Traditionally, commodities are traded in the pits, and in order to trade, a speculator would need to contact a broker by phone to place the order, who then transmits that order to the pit for execution. Once the trade is complete, the pit operator informs the broker, who then informs the client of him. This can take some time and the risk of landslides can be high. Online futures trading can help reduce this time by providing the customer with a direct link to an electronic exchange.
You might find a truckload of corn at your doorstep! In reality, most futures contracts are not deliverable and are cash settled at expiration. However, some, like corn, can be delivered, although you will get plenty of warnings and the chance to close out a position before the truck shows up.