The Complete Guide to Investing in Commodity Trading & Futures: How to Earn High Rates of Returns Safely

The Complete Guide to Investing in Commodity Trading and Futures

How to Earn High Rates of Returns Safely

By Mary B. Holihan

THE SECRETS TO SUCCEEDING IN NETWORK MARKETING OFFLINE AND ONLINE: HOW TO ACHIEVE FINANCIAL SUCCESS SELLING NETWORK MARKETING PRODUCTS & SERVICES

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ISBN-13: 978-1-60138-003-6

ISBN-10: 1-60138-003-8

Library of Congress Cataloging-in-Publication Data

Holihan, Mary B., 1947-

The complete guide to investing in commodity trading & futures : how

to earn high rates of returns safely / by Mary B. Holihan.

p. cm.

Includes bibliographical references and index.

ISBN-13: 978-1-60138-003-6 (alk. paper)

ISBN-10: 1-60138-003-8 (alk. paper)

1. Commodity exchanges--United States--Handbooks, manuals, etc. 2.

Futures market--United States--Handbooks, manuals, etc. I. Title.

HG6049.H65 2008

332.64’4--dc22

2008011366

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Table of Contents

Dedication

Part I: The Basics

Chapter 1: Commodity Basics

Chapter 2: Understanding the Markets

Chapter 3: The Whys of Commodity Trading

Chapter 4: How to Get Into Commodity Trading

Chapter 5: Fundamental Analysis

Chapter 6: Technical Analysis

Chapter 7: Pitfalls

Chapter 8: Building Strengths

Part 2: Trading the Commodities

Chapter 9: Agricultural Products

Chapter 10: Metals

Chapter 11: Oil and Gas

Chapter 12: Meats

Chapter 13: Currencies & Financial Instruments

Chapter 14: A Final Word from the Experts

Chapter 15: Moving Forward

Bibliography

Biography

More Great Titles from Atlantic Publishing

Dedication

I am deeply grateful to my wonderful family and friends and to the love of my life, Kevin, for constant, unwavering support.

Table of Contents

Introduction

A lot of people make a lot of money in commodities. A lot of people lose a lot of money in commodities. The days of buying a real estate property for $5,000 and turning it around to a profit of $100,000 are long over, but in the commodities futures markets, it is still possible to turn $5,000 into hundreds of thousands. For example, Richard Dennis, the Prince of the Pit, started in the Chicago Board of Trade as a runner and over a ten-year period parlayed a few thousand dollar investment into a fortune of more than $200 million. Dennis’ firm belief was that successful trading was a talent that could be learned and it was not an innate talent, possessed by only a few gifted individuals.

The efficiency of markets, combined with the seemingly unlimited information capacity of the internet has made information regarding markets, commodities, trading systems, news, etc. quickly available to any market participant who seeks them out. In this book, you will see how using the vast amount of information available to everyone can be used to become a successful trader. The problem for most people is they insist on treating commodities trading as a get-rich quick scheme, akin to playing the lottery or gambling in a casino. Commodity trading is a business; just as in any business, you do the proper research, build a plan, and examine your risks before you make each sale, deal, or transaction. This is what separates the professionals from the amateurs. As in any business, hard work and dedication yields results; profits don’t just happen. The people who lose big are the ones who do not have the patience to study the available information, are not willing to wait out markets, perhaps most importantly, are not able to control their risks but instead take big risks in the hopes of winning big in a very short time. Take the example of Richard Dennis above. Two hundred million dollars is certainly a great fortune, but he studied and worked the markets for ten years to achieve this impressive result.

As you decide whether to enter the speculative commodities trading market, the first step is to be aware of all of the risks involved, analyze them, and, above all, be comfortable with them. In any area of business (or even life!), risk cannot be eliminated, but it can be managed. For the most part, through the use of stop-loss orders, hedging, and staying informed about the market, losses can be predicted and managed. In the event of major market moves, the losses can mount up, but even those can be restricted by an important guidelines we will discuss in this book, including one of the most important ones, never answer a margin call. Using conservative trading methods such as the one you will learn here allows a trader to control losses within reasonable limits, determined by the risk he can afford to take. Traders who cannot face the inevitability of loss should not be trading at all; most successful traders look at their losses as a cost of doing business, cut or minimize them as quickly as possible, learn from them, and then move on to the next trade.

Table of Contents

Part I

The Basics

Table of Contents

Chapter 1

Commodity Basics

Chance favors the informed mind.

— Louis Pasteur

The Concept of Commodities

Commodities are the basic raw materials of just about everything we eat and use. As such, they have been sold and traded for thousands of years as man discovered a use for each kind of commodity. Most of the products traded in the commodity markets are essential to life as we know it: food products, metals and oil. We survive on food, build our economies with metals, and power them with oil. Unsurprisingly, agricultural commodities were the first commodities to be traded in a futures market; the concept is eons old, as we shall observe, and has spread to many other raw materials and has now grown to include that rawest material of all, money. In addition to agricultural commodities, metals (such as gold and silver), and oil and petroleum-based products, there are futures contracts for intangible commodities such as interest rates, currencies, and bond and stock market indices. (The commodity is the actual good that is traded; commodity futures are exchanged on commodity exchanges. Commodity futures are also called derivatives. There are many types of derivatives trading because the value of the future is derived from the actual good.)

How did the first commodities futures markets come to be formed? It all started, as we would expect, with the human survival need for foodstuffs. Maintaining a year-round supply of seasonal crops and products has always been problematic, and solving this problem led to a system that we know today as the futures trading markets. The first recorded instance of futures trading occurred in the rice trade in 17th century Japan, although there is also evidence indicating rice futures in China 6,000 years ago. In the precursor to today’s futures trading system, these 17th century Japanese merchants would store rice in warehouses for future use. To raise cash while they held these stocks of rice, the warehouse owners sold receipts against the stored rice, known as rice tickets. Over time, these rice tickets became accepted as a kind of general commercial currency, especially since rice was such a pervasive commodity of the entire economy. To assure that everyone could understand the value of the rice tickets, and to make sure there were common standards to indicate the value of each ticket, rules were gradually developed that standardized the trading of these rice tickets. Eventually, futures trading as we know it today grew out of these rules. We will see how the principle of rice tickets is mimicked in the concept of original warehouse receipts that made modern commodities futures trading possible.

Commodity markets, in one form or another, have persevered. Even during medieval times, when culture was destroyed or ignored and society became relatively static, trade associations organized by merchants continued the tradition of bringing things to market. An interesting study by Gregory Clark of the department of economics at University of California-Davis, Markets and Economic Growth: The Grain Market of Medieval England showed how these ancient traders were able to bring efficiency to markets that is still today the hallmark of commodities trading. For example, in a very thorough analysis of the prices of grain in the various manors of southeast England during the years 1300-1349, he showed that if prices were lower on some manors than others because they had grain surpluses, the price gap represented the transportation costs of the consumers of the grain in the distant areas. This efficient market hypothesis still rules grain prices today. Distances between producing and consuming areas explain price differentials because transfer costs, which today, of course, include loading or handling the grain and transportation charges, which include equipment and fuel prices are the most important variables in determining grain price differentials. For this reason, price differentials between regions cannot exceed transfer costs for very long. If this situation occurs, equilibrium will quickly be found as buyers purchase commodities from the low-priced market (raising prices there) and ship them to the higher-priced market (lowering prices there). As we have seen, this market pricing mechanism has existed for hundreds of years.

So we can see that these ancient markets are the precursor of the exchanges that we have today. But the real foundation of the commodity exchanges that trade many of the products discussed in this book has its roots in the Chicago Board of Trade, in the mid-1800s.

As is the case with so many of the advances of the 19th century industrial revolution, the invention of the steam locomotive was the engine (pun aside) of growth for the commodities markets. The railroad made high volumes of grain shipment possible and allowed farmers to secure larger loans on their crops. These loans traditionally were secured by warehouse receipts (following the tradition of the Japanese rice tickets of two hundred years prior) for a particular quantity of grain. This increased volume led to active transfer and trading of these warehouse receipts. This required that grains be fungible, or according to Merriam-Webster’s dictionary, being of such a nature that one part or quantity may be replaced by another equal part or quantity in the satisfaction of an obligation. Commodities, options, and securities are all considered fungible assets since they can be freely interchanged. For example, an investor’s shares of IBM held for the investor by a brokerage firm are freely mixed with other customers’ IBM shares. By the same token, stock options are interchangeable among investors, and a quantity of wheat stored in a grain elevator is not specifically identified as to its ownership. In this manner, grain warehouse receipts could be used as an exchangeable representation of the underlying good in order to act as collateral for a loan.

These loans could be more easily secured if the underlying collateral had a firm price and quantity commitments from a buyer. This is why merchants began to engage in forward contracts. According to Thomas Hieronymus, in his book Economics of Futures Trading for Commercial and Personal Profit, the first such time contract on record was made on March 13, 1851. It specified that 3,000 bushels of corn were to be delivered to Chicago in June at a price of one cent below the March 13 cash market price. Still today, this is almost exactly the way a futures contact would be quoted on a futures exchange.

How the Commodity

Market Functions

All futures markets function in the same way: they are markets in which commodities or financial instruments are bought and sold for purchase or delivery at some future date. Each of these agreements to buy or sell is called a futures contract. When futures are traded, nothing is actually bought or sold, just the right to a contract representing a given quantity of a good. Traders buy and sell these futures contracts with the expectation of either selling them at a higher price or buying them back at a lower price, thereby earning a profit, with no actual interest in the corn or whatever commodity the contract represents. Before the expiration period of the contract is over, the buyer or seller will offset his position. That is, he will sell enough contracts to zero out his purchases of contracts, or he will buy enough contracts to zero out his sales of contracts. If he guessed right on the direction of the price movement, he will sell the contracts for more than he paid for them or he will buy the contracts at a lower price than he sold them for and he will make a profit; if he guessed wrong, he will have to sell the contracts for less than he paid or buy the contracts for more than he sold and he will incur a loss.

Each futures contract traded is for a very specific quantity of a very specific commodity. In other words, when a trader offers to buy a contract of soybeans, he knows he is dealing with a promise to buy 5,000 bushels of GMO or a mixture of GMO and Non-GMO No. 2 yellow soybeans of Indiana, Ohio and Michigan origin produced in the U.S.A. (Non-screened, stored in silo), and of deliverable grade if they are GMO or a mixture of GMO and Non-GMO No. 2 yellow soybeans of Iowa, Illinois and Wisconsin origin produced in the U.S.A. The buyer of this soybean contract does not necessarily care that the beans are from Indiana or Ohio, but only that it is a exact grade that will match the grade that he will have to sell when he liquidates the position to make his profit. Each commodity is traded on its own exchange and has its own such standard. Thus, a coffee contract on the New York Coffee Exchange is for 37,500 pounds of one of the five grades of coffee traded on that exchange, a corn contract on the Chicago Board of Trade is for 5,000 bushels of corn, and a British Pound contract on the Comex is for £62,500. The exchanges require that all contracts represent a standard grade of the product. Gasoline futures traded on the NYMEX are based on the contract specifications for New York Harbor Unleaded Gasoline. In this way, everyone is comparing apples to apples. Finally, there is standardization in each contract’s minimum price fluctuation, or tick," based on the underlying measurement of the commodity. Therefore, the price fluctuation for coffee is 10 cents per ounce, for corn, ¼ cents per bushel, etc. Except for grains, minimum fluctuations are generally quoted in points.

These are basically four legs of a commodity contract: how much of a given quantity of a commodity is being traded, what the exact specification of the commodity is, the delivery date, and the payment specifications. Some contracts may also have daily price limits; this is the maximum amount that the market can move above or below the previous day’s close in a trading session. Exchanges decide whether a commodity has a trading limit and how much it is. The Exchanges use this limit move rule to slow markets down when dramatic price swings occur. A commodity can trade up to or down to the limit price, but not above or below it. If there are too many buyers chasing too few sellers, the market locks at the limit up price, and if there are too many sellers and not enough buyers, the market locks at the limit down price.

The theory behind this limit-move rule is to allow markets to cool down when there are violent price moves. The soybean contract on the CBOT, for example is only allowed to move up or down 50¢ per bushel from the previous day’s close. If the market closed at $8.00 on Monday, then on Tuesday it would only be allowed to trade as high at $8.50 or as low as $7.50; the price offered cannot go above $8.50 or below $7.50. In volatile markets, the price can move to the limit and then, since it can go no further, it will lock at that price. Lock limit up means that there are too many buyers versus sellers at the limit price and lock limit down means that there are too many sellers versus buyers at the limit price.

The other important element of the commodity futures market is the concept of clearing. Each buyer or seller does not really exchange a contract for an amount of money. This is next to impossible because off-setting purchases and sales between traders rarely balance with respect to quantity. A brokerage firm will do business with a clearinghouse, the ultimate buyer and seller of commodity contracts. Simply put, the clearinghouse matches buyers with sellers, and this is one of the most important components of commodities trading.

Each of the futures exchanges has its own clearing house and all members of the exchange are required to clear their trades through their clearing house at the end of each trading session. (They are also required to deposit with the clearing house a sum of money based on clearinghouse margin requirements sufficient to cover the member’s debit balance, but we will discuss margin requirements in detail later on.) For example, a member broker reports to the clearing house at the end of the day total purchase of 100,000 bushels of July corn and total