The Basics of Commodity Futures Trading

Just what is commodity trading? Well lets look at first what a commodity futures contract is:

Commodity Futures Contract:

A transaction in the commodity futures market is made on the trading floor (or in the trading computers) of the exchange between brokers who are members of the exchange that particular commodity is trading on. The seller will have a broker, and buyer will have a broker. They will then transact an order for a purchase and sale.

The buyers and sellers of commodity futures contracts have obligations. The buyer is obligated to take delivery and pay for the cash commodity during a specific time frame. The seller is obligated to deliver the commodity, for which he will be paid the price that was decided in the exchange pit by the brokers. (Sometimes the price can be more or less depending on the grade (quality) of the specific material.) The buyer and seller can eliminate their obligation by offsetting their trade at the exchange before the contract comes due. This is what most speculators do in the commodity markets.

Speculators:

There are speculators and hedgers that trade in the commodity markets. (A hedger is not interested in making a profit off the movements in price of a commodity futures contract, but rather in shifting his risk of loss on the commodity itself due to adverse price change.) Speculators will buy and sell futures, or options on futures, for the purpose of making a profit. They will buy futures (a long position) when they think prices will rise, or they will sell futures (a short position) when they think prices will fall. Both the speculators and hedgers add volume to a market making it a more liquid market to trade.

Most individuals who open commodity trading accounts are speculators looking to benefit off of the price movement of the commodity being traded. Farmers, oil operators, cattle companies, etc could open a commodity futures trading account looking to be a hedger and reduce their risk of price movement.

Trading:

Here is a simple example of a speculator (we will call him a futures trader) executing a trade and how it would work. Once the futures trader has established a futures trading account, he would then call his broker to initiate a trade. He would let the broker know if he was looking to buy or sell (long or short), the specific commodity he wants the trade in, the month and year of the contract he is looking to trade, the quantity, and the price which he is willing to buy or sell for (or he can say Market Order to have the trade executed at the current market price in the trading pit).

Example: The futures trader calls his broker and says "I would like to buy One March 2007 Corn futures at the Market Price." The broker would then take this futures order and relay this to the trading pit at the exchange, where the order would then be executed by brokers on the floor. (Sometimes conditions are present when the trade can not be executed for some reason which is rare but can happen.)

After the trade is executed, the floor broker would relay price paid or sold and relevant information back to the trader's broker. The futures trader's broker would then let the futures trader know the price that the Buy or Sell (the trade) was executed.

In recent times, more trading has been done through the use of online futures trading, eliminating the use of telephones and calling of brokers on the telephones. The futures trader can trade directly from their computer and have the trade routed directly to the trading floor of the exchange. At the exchange some orders (electronic markets) are executed immediately in the exchanges computers. This is becoming the more preferred method of trading because it tends to be quicker.

Lets say the futures trader got his price back (the fill price) and he bought one March Corn at $3.10. He then watches the futures quotes and sees the price trading higher at $3.15. He then calls his broker (or enters an order into his computer trading platform) to sell the futures contract he has bought earlier in the day. He tells his broker "I would like to sell 1 March 2007 Corn at the Market Price." The broker then relays this to the trading pit where the trade is executed and reported back to the futures trader. Lets say the price he received for the sale was $3.14.