A Quick Intro to Commodity Futures Markets

“Sugar, Soybeans, OJ and Coffee.”

That’s not a secret formula to provide energy throughout the day (or the answer to a recent Jeopardy question).

I am referring to just a few of the commodities that have been traded for years on exchanges such as the Chicago Board of Trade (CBOT), Chicago Mercantile Exchange (CME), and New York Mercantile Exchange (NYMEX).

The CBOT and CME have since merged, and although the original “pit trading” open outcry method dominated for decades, close to 70% of all CME trading now takes place electronically.

This trend continues to rise, and I foresee the industry getting to 100% electronic before long. Pit traders and nostalgics may miss the ticket-covered trading floors, the brightly colored floor jackets and the hand signals of old, but we’re never going back.

Enough reminiscing about the past, though. Let’s talk more about how futures markets work.

Let’s quickly cover something for those new to futures: In case you weren’t certain, “futures trading” and “commodities trading” are basically the same thing. Futures contracts cover the broad range of commodity markets  energy, metals, agriculturals, softs, livestock  though they also cover financial markets as well (indices, currencies, interest rates, single stock futures).

A futures contract is simply an agreement to buy or sell at a price set today, for a future delivery date of the commodity in question.

So if, say, the December corn contract is trading at $5.96 per bushel, and a corn farmer likes that price, he can “lock in” $5.96 per bushel nine months early by selling December corn contracts against his crop.

If the price of corn falls by December, the farmer will get less for his crop in the cash market, but will make an offsetting gain on the futures contracts. If the price of corn rises, the futures contracts will show a loss  but the farmer will gain on the cash side.

On the other side of the coin, General Mills is a big commercial buyer of oats for its cereal products. So if General Mills likes the price of December oats at $2.95 per bushel, it can buy oat contracts now and “lock in” that $2.95 price before it goes higher. This mitigates the buyers’ risk of a big price spike in the cash market due to drought, flood, and so on.

Either way, futures contracts provide a “hedge” so that producers and commercial end users are not exposed to ruinous price swings. This was, in fact, the original rationale for futures markets: Offering a way for commodity users and producers to transfer their risk to willing speculators, who take on that risk in pursuit of profit.

What are some reasons to trade futures? Offhand I can think of at least five: Capital efficiency, tax efficiency, diversification, ease of trading long or short, and enhancing skills and performance.

First, up, capital efficiency:

The most infamous aspect of futures markets is leverage. While leverage is a two-edged sword, one that cuts those who get carried away, the sword has numerous advantages.

Just as one options contract controls 100 shares of stock at a fraction of the cost of purchasing those shares, a futures contract controls a very large stake in the underlying commodity. The “margin requirement” on a futures contract is actually not even a form of payment. It is just a “good faith deposit” in the event that the position generates losses.

While there are many commodity based exchange traded funds (ETFs) these days, none of them offer anywhere near the actual leverage embedded in real futures contracts. (The ETF currency contracts are the worst; their leverage is so low, the capital efficiency is just terrible.)

This is deliberate, as the authorities want it harder for Joe Sixpack to find leverage via his stock brokerage account. But the reduced leverage of stocks and ETFs makes it harder to take meaningful trend style positions… a big reason why the original trend followers all made their fortunes in futures markets.

Next up, tax efficiency:

Most futures trades are taxed at a more favorable rate than stock trades. Whether you hold a futures trade for two weeks, two months or two minutes, the capital gains will be tallied at 40% short-term / 60% long-term, regardless of holding period.

Compare this to stock trades which, if they are short-term, will be taxed 100% at the punitive short-term rate. That kind of tax break can lead to meaningful savings, especially for high volume traders.

Third, diversification:

If you are only trading stocks, adding uncorrelated markets and strategies to your portfolio can significantly enhance long-term returns. The stock market can get stuck in the doldrums for years  and if you only trade stocks from the long side, you are that much more exposed as you won’t make money in prolonged downswings.

Assuming you are diversified because you have an emerging market fund, a small cap fund and a dividend income fund in your portfolio is worlds apart from having multi-directional exposure to the S&P, crude oil, corn, t-bonds and cotton. Chances increase that, even if the S&P is going nowhere, a bull or bear trend is happening elsewhere (and delivering hefty profits).

Another futures advantage – ease of trading long or short:

Compared to the ease of buying them, it is notoriously hard to short stocks. There are uptick rules, and borrowing requirements, and the risk of outright short selling bans when authorities feel panicked. But in the futures markets, it is always just as easy to sell short as it is to buy long. With futures contracts, it doesn’t matter at all whether you buy first or sell first. No one cares.

And there is no stigma or media bias with shorting futures either. No one will call you names on CNBC or accost you at a family gathering for shorting cotton. Compare that to, say, shorting General Motors or heaven forbid Apple. If I short General Motors, be sure I’ll keep it under wraps at the family barbecue.

And last but not least, futures can enhance skills and performance:

I believe any time you step outside your comfort zone, you open yourself up to potentially great things. Even if you try commodities and simply don’t like trading them, I can’t imagine not picking up some useful skills and observations that transfer over to the markets you trade now.

If you are a technical trader, you may appreciate the purity of commodity price patterns, and see new ones jump out at you after some time in the trenches. And if you are working on impulsiveness and risk control, the extra leverage in futures could teach you well with just one improperly attended loss.

Precaution: Not for the Faint-Hearted

Let it be said though: The futures markets are certainly not for everyone. There is a reason why it is harder to open a futures account than a plain vanilla stock brokerage account  and why you have to sign a number of scary forms spelling out that 1) “I understand the risk,” and 2) “I know I can blow myself up if not careful.”

Come to think of it, they should have that exact same language for stock investing too…

But anyway, point being, the inherent leverage in futures must be respected and taken seriously. There are great opportunities, but only for those who can follow a rational plan and have a natural respect for risk.

To get used to the bigger swings, I recommend easing into commodities rather than jumping in whole hog, using mini contracts if feasible and only a portion of available risk capital. Some contracts are also much more “beginner friendly” than others: Oats yes, natural gas no!

If popular demand calls for it, we’ll continue this discussion with more on the mechanics of commodities - a must read for those who have never traded on the dark side. Also, if you have any specific futures-related questions, let us know!

Disclosure: This content is general info only, not to be taken as investment advice. Click here for disclaimer