Commodity Futures Trading Markets, Basic Information

Long before man began to trade stocks and bonds, man had been trading commodities. From it’s beginning commodities trading has evolved and changed with changing times. Commodity futures trading has become a major trading arena where producers, merchants and speculators trade futures contracts for price protection and profit.

Commodity trading is different from trading stocks as to the fact that while stocks are based on the future expectations of the buyer, commodity futures have an underlying instrument. A person who owns one CBOT corn futures contract, is the holder of the right to 5.000 bushels of corn or 127 tons of corn, and if this contract is not offset before the contracts expiration date, the holder of the contract will be delivered the corn. As such there are tangible items connected to the contract. An owner of five shares of a company, is the owner of five shares of a company. He holds a paper saying that. This paper can be bought or sold, but the value of the paper is based on feelings and expectations, with no tangible items connected to it. It’s basically an IOU.

Valuating companies can be done in various way’s. One can look at the accounts, profits and losses. Different values can be calculated with reference to earnings pr. share, hidden property values or goodwill. Commodities are different as there is no one place to retrieve information. It’s not like a company where you can contact the office and get the latest annual report. The value of a commodity is based on things related to the physical presence of the underlying commodity. Weather, stock in warehouses, harvest and demand and supplies issues affect the valuation of the commodity. The vast amount of information needed to valuate the different commodities makes it difficult to put a certain price on each commodity.

Two main analytical theories are being used in trading markets. On the one side is the fundamental analysis, the one mostly used in trading stocks, and on the other is the so called technical analysis. Fundamental analysis work with news, information and what has been categorized as facts. When trading stock, fundamental analysis are to some use, as they are mostly based on the companies annual reports and items related to the companies business. As mentioned before, commodities are a bit different, and as such fundamental analysis can be a bit more difficult and demanding. The enormous amount of information and data to analyze makes it difficult for the trader to be informed about all relevant facts related to the commodity he’s trading. This makes it very difficult for normal people to trade commodities using fundamental techniques. Let’s say for example that there is a change in sea temperature close to Chile. Should you then buy or sell Soybeans. Well we could imagine that there is a certain small fish that stays close to the shore or far off it, depending the temperature. So if the fish moves away from the shores, there is less fishing. This means that there will be less fish to make fishmeal and that could mean less import of meal to Japan. The Japanese would therefore have to look for other sources of meal and then the soy meal would be an option. Increased demand for soy meal would then increase the demand for soybeans and that would increase the price. As can be seen from this example, there is no way a trader can follow all the facts relating to the fundamental basis of a soybean price move.

Technical analysis are, one the other hand, based on the market prices, volume and open interest. This makes it possible for normal people to participate in the futures markets on level playing grounds. Everybody can have access to the same information at the same time. The theory states that even though it’s impossible for any trader to know all the facts, the market as a whole has got all the facts and the relative weight of those facts is visible in the price. Technical analysis and trading has another inherent feature that makes it more appealing to use rather than try the fundamental approach. This feature is systematic trading. By basing all trade decisions on underlying price, it’s movements and the markets volume and open interest, it’s possible to setup a trading system that analyses the market in a systematic way and as such cutting out human emotions and feelings. The decision to enter into a trade is based on facts only and not subjected to the whims of the person trading.

Agricultural Futures

Agricultural products are the products that have been traded since the beginning of human civilization. Basic necessities have and always will make it viable to trade agricultural products. During the nineteenth century, the agricultural markets went through big transformations in reference to quality and quantity. The new environment prompted the use of Futures as a way of managing risk and a source of profit for individuals willing to take a risk.

Agricultural products can be grouped in three main categories, Grains, Livestock and Softs or Exotics. These categories show the pain production types of agricultural products, but even though they are different in essence, due to environment factors or workload, they all have certain common aspects. All agricultural products are grown in one way or another and the production is almost always highly connected to external factors. Grains and Exotics are highly vulnerable to weather and environmental changes and Livestock is highly vulnerable to feed production. The growing of the agricultural products makes there prices also vulnerable to seasonal swings related to the production phases. The different production phases have affected the way production years are defined. The bulk of the corn is harvested in October, thus the corn crop year is from October to October. Other months relate to other product cycles. This fact in turn affects the price swings, which tend to follow the crop year. Another factor is the carryover or surplus. Every year some of last years production has been kept in stock and this stock is forwarded to the next year, added to that years production. Carryover has therefore a big impact upon the price, as large carryovers can maintain or even lower the prices for the coming year.

Grains

Grains are mostly traditional agricultural products from the northern hemisphere, such as corn, wheat and soybeans. Corn Futures have been traded on Chicago Board of Trade since 1859 and is to day one of the most traded agricultural product in the States, but the United States are the largest producer of corn in the world. Soybeans and it’s products have been increasing in importance throughout the twentieth century and the trading volume has been paralleled in that development. It’s products, soy meal and soy oil have grown in importance as high quality products, meal as protein rich animal feed and the oil as a high quality food processing ingredient. The increased importance of soybeans has worked against other traditional products as corn, wheat and especially cotton, as many farmers have moved away from those products and into soybeans. Wheat is a bit different from the other agricultural products in respect to variety and different planting seasons. Wheat, being one of the most important ingredient of the human diet, has been traded since the 1800’s and is an important part of the commodities Futures trading market. Cotton is the agricultural product that has seen the most difficult times. With the advent of synthetic fabric, cotton has become to expensive and thus the demand has lowered. Lately the demand for cotton has began to increase, possible due to the fact that polyester is 95% based on oil and with increasing oil prices, cotton begins to look like an interesting alternative. Increased acreage moved out of cotton production and into soybeans has also helped support the increased demand for cotton, as less cotton is being produced every year. Though cotton has been categorized with the Grains in this text, it’s often group with the Softs or Exotics.

Softs or Exotics

Softs or Exotics are tropical products and orange juice. These products are more related to global supply and demand than the agricultural products, which tend to be more related to US demand and supplies. Coffee is probably the most known of these products and most actively traded. Both London and New York are trading coffee and it’s prices often correlate with both markets. Coffee has been grouped in two main products, Arabica and Robusta, where Arabica is mainly produced in South America and traded in New York, and Robusta being mainly an Asian product traded in London. While Brazil is the leading producer of Arabica coffee, Vietnam is the equivalent in the Robusta production. One of the main factors in the production of coffee and it’s possibility to follow demand, is the fact that it takes five years for new coffee trees to start growing beans. Increased consumption of coffee will therefore take five years to fulfill. Cocoa is a subtropical plant like coffee and has the same limitation when following increased demand, as the cocoa trees take four years to bear fruit. Both cocoa and coffee have very long price cycles. Sugar has been grown both in tropical and tempered areas as the sugar comes from two main products, sugar beets and sugar cane. The cane is a tropical plant and the beets are tempered. The fact that the European Union has been cutting down on the production of beets, has increased the price of sugar to the effect that it has multiplied since 2005. Orange juice was predominantly produced in Florida, but with changes in climate and weather it’s production has moved increasingly to Brazil. Florida has also had severe infection problems during the last few years. But even though the importance of Florida as a producer of orange juice, it still has a huge effect on the market price.

Livestock

All products related to the breeding of live animals is categorized as livestock. The prices of livestock is highly connected to weather and the price of Grain products. Live and feeder cattle are contracts of cattle at different stages of the production. Live cattle Futures are for cattle already at slaughter weight, while feeder cattle Futures are cattle of weight to be sent to feedlots to be fattened. These products are therefore highly correlated when it comes to pricing. Lean hog Futures where introduced into the market in the 1990’s in response to the markets demand for leaner pork, thus replacing the hog Futures contracts. Pork bellies, when cured and sliced, become bacon and as there is no comparable substitute, represents a significant portion of the value of a hog. The pork bellies are sold both fresh and frozen, but it’s the frozen pork bellies that dominate the market in terms of trading activities.

Metals Futures

Since before recorded history, metals have played an important role in the development of the human species. Metals are categorized in two main groups, precious and none precious metals. Precious metals have survived as a valuable item in exchange for goods or services through the ages outliving governments, states or currencies. none precious metals have also survived the enormous changes in human history. The two main Futures markets for metals are the New York Mercantile Exchange and London Metal Exchange.

The main types of metals in each group are gold, silver, platinum and palladium as precious and aluminum, copper, lead, nickel, tin and zinc are the major none precious metals. Gold and silver have long been the metals of choice when it comes to items used in exchange of goods and services. While gold is the favored one, silver has maintained its value as a decorative and utility metal. Palladium and platinum are precious metals used in the industrial worlds and with the advent of computer technology, have increased in value.

None precious metals have been increasing in value as the new economies of the east, notably China, have increased its consumption. There is still a large market for none precious metals in Chine that has not been filled and it’s not going to be filled in the nearby future.

Energy Futures

In the 1970’s the energy markets went through immense changes as the power of energy went from the US to the Middle East. The oil crises of the early 70’s opened the way for high volatility in energy prices and following those turmoil times, energy Futures began to be traded on US markets. In 1978 the New York Mercantile Exchange began offering heating oil Futures contracts, followed by gasoline in 1981, crude oil in 1983, natural gas in 1990 and electricity in 1996.

The world political environment has shown the last few years, that these markets are not going to die down in the near future. The volatility of these markets will ensure the tradeability of these markets and the possibilities that come with that.

Financial Futures

Foreign exchange markets or FOREX is a huge financial market traded 24/7. The FOREX and other financial instruments, such as bonds and indexes have been growing in popularity with the arrival of Futures into the market. While FOREX trading has various aspects connected to the trading, such as interest rate calculation, Futures have proven to be an valuable alternative as they do not incur any additional cost other than the brokerage fees.

Foreign exchange Futures were introduced by the Chicago Mercantile Exchange in 1972. The vast amount of currencies traded have given rice to the value of the market, both as a speculative venue and as a way for hedging currency price fluctuations.

In 1982, Futures on broad based stock indexes began to trade and since then the Futures stock indexes have been used as a hedging method for index based portfolios. By trading stock indexes, it’s possible for large owners of index based portfolios, to hedge against market corrections. By selling SP500 index Futures, a portfolio owner can fix the prices of his portfolio and survive long draw-downs in the market.

Fundamental changes in the interest rates in the 1970’s prompted the needs for risk management tools for individuals as well as large corporations. In 1975 Chicago Board of Trade began offering interest rate Futures contracts. T-bills and Treasury bonds began to be traded on various Futures exchanges.

People wanting to trade commodities should be aware of the following:

THE RISK OF LOSS IN TRADING COMMODITIES CAN BE SUBSTANTIAL YOU SHOULD THEREFORE CAREFULLY CONSIDER WHETHER SUCH TRADING IS SUITABLE FOR YOU IN LIGHT OF YOUR FINANCIAL CONDITION. IN CONSIDERING WHETHER TO TRADE OR TO AUTHORIZE SOMEONE ELSE TO TRADE FOR YOU, YOU SHOULD BE AWARE OF THE FOLLOWING.

IF YOU PURCHASE OR SELL A COMMODITY FUTURE OR SELL A COMMODITIY OPTION, YOU MAY SUSTAIN A TOTAL LOSS OF THE INITIAL MARGIN FUNDS AND ANY ADDITIONAL FUNDS THAT YOU DEPOSIT WITH YOUR BROKER TO ESTABLISH OR MAINTAIN YOUR POSITION. IF THE MARKET MOVES AGAINST YOUR POSITION, YOU MAY BE CALLED UPON BY YOUR BROKER TO DEPOSIT A SUBSTANTIAL AMOUNT OF ADDITIONAL MARGIN FUNDS, ON SHORT NOTICE, IN ORDER TO MAINTAIN YOUR POSITION. IF YOU DO NOT PROVIDE THE REQUESTED FUNDS WITHIN THE PRESCRIBED TIME, YOUR POSITION MAY BE LIQUIDATED AT A LOSS, AND YOU WILL BE LIABLE FOR ANY RESULTING DEFICIT IN YOUR ACCOUNT.

UNDER CERTAIN MARKET CONDITIONS, YOU MAY FIND IT DIFFICULT OR IMPOSSIBLE TO LIQUIDATE A POSTION. THIS CAN OCCUR, FOR EXAMPLE, WHEN THE MARKET MAKES A “LIMIT MOVE.”

THE PLACEMENT OF CONTINGENT ORDERS BY YOU OR YOUR TRADING ADVISOR, SUCH AS A “STOP-LOSS” OR “STOP-LIMIT” ORDER, WILL NOT NECESSARILY LIMIT YOUR LOSSES TO THE INTENDED AMOUNTS, SINCE MARKET CONDITIONS MAY MAKE IT IMPOSSIBLE TO EXECUTE SUCH ORDERS.

A “SPREAD” POSITION MAY NOT BE LESS RISKY THAN A SIMPLE “LONG” OR “SHORT” POSITION.

THE HIGH DEGREE OF LEVERAGE THAT IS OFTEN OBTAINABLE IN COMMODITY TRADING CAN WORK AGAINST YOU AS WELL AS FOR YOU. THE USE OF LEVERAGE CAN LEAD TO LARGE LOSSES AS WELL AS GAINS.

IN SOME CASES, MANAGED COMMODITY ACCOUNTS ARE SUBJECT TO SUBSTANTIAL CHARGES FOR MANAGEMENT AND ADVISORY FEES. IT MAY BE NECESSARY FOR THOSE ACCOUNTS THAT ARE SUBJECT TO THESE CHARGES TO MAKE SUBSTANTIAL TRADING PROFITS TO AVOID DEPLETION OR EXHAUSTION OF THEIR ASSETS.

THERE IS A CONSIDERABLE POSSIBILITIES OF HUGE LOSSES AS WELL AS PROFITS IN TRADING COMMODITY FUTURES CONTRACTS.

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