Should You Trade Commodities and Futures?

While the stock market has plunged here in August 2011, and markets like gold and silver have soared to new heights, many investors are probably asking themselves whether they should invest in commodities and futures. For the vast majority of those people, the answer is NO. The futures trading business is dominated by professional traders who have are well educated in the risks inherent in trading futures. While commodity, currency and bond markets move in a similar fashion to stocks, there is significantly more risk involved due to the leverage employed in both futures contracts and in the forex (foreign exchange) markets.

Futures markets are structured in a way so that small speculators can invest in a commodity such as corn by putting very little money upfront. For instance, in the corn market, one contract represents 5,000 bushels of corn. Presently, with corn futures trading at over $7.00 per bushel in August 2011, the amount of money it takes to trade one contract, known as initial margin, is $2,363. So, $2,363 controls a contract worth over $35,000. Therefore, the leverage is over 15:1.

On a daily basis, corn futures tend to trade within a trading range of 10 to 20 cents. A one cent move in corn is worth $50. Therefore, the daily range may result in a change in account equity of $500 to $1,000 on just a normal trading day. On days where significant news may impact the market, it may actually open above or below the previous day's closing price by 15 cents or more. In some cases, if it opens locked limit up or down (the amount the contract may move in a single day is the limit), it will open up or down by 30 cents, which equates to $1,500.

With that in mind, if a trader opens an account with $5,000, which is common, and buys a corn contract in hopes that the price will go up, and the price opens down 20 cents, the trader has immediately lost 20% of their equity in the account!

Incredibly, corn is one of the LEAST volatile markets. For instance, a $1 move in the price of gold is worth $100 in the normal sized contract, which involves 100 troy ounces. Lately, gold prices have been moving at a trading range of $20 to $30 per day, and sometimes up to $50. A $50 move in the price of gold in the wrong direction would wipe out the entire contract of the trader with $5,000. Of course, the margin requirements for gold are significantly higher than for corn, so the trader in this case would be unable to trade in the normal sized gold contract. While there are mini-sized contracts in many markets, unfortunately, for most commodities, there is simply not enough volume to allow for trading without significant slippage. Slippage is the difference between the price the trader intended to execute the trade and the actual price where the trade was executed. The less volume and liquidity in a market, the more slippage expected.

Most individual traders with small accounts are attracted to commodities and futures, as well as the forex markets, by the leverage involved. They think that it is a way to make money fast. For some, it definitely is, but they are the lucky few. The fact is, 90% or more of futures traders are unprofitable because they do not start out with enough capital.

It was mentioned that the commodities and futures trading business is dominated by professional traders. These traders typically manage at least $10 million, and some have several billion dollars under management. While many have enjoyed long term success, they have also experienced some bad years as well, where they may have lost 20% of their equity under management, or more. Therefore, these traders tend utilized very little leverage when they trade these markets. Their goal is to provide their investors with positive returns with as little volatility as possible. Unfortunately, when there are only 50 to 60 very liquid markets to choose from, it is not always possible to limit this volatility.

Take for example John Henry. John Henry is the owner of the Boston Red Sox and he amassed his fortune through managing money in the futures and forex markets through his firm, John W. Henry & Company. At their peak, they managed over $1 billion for institutional investors. Commodity Trading Advisor firms such as this are typically paid a management fee of 2% of equity under management, and an incentive fee of 20% of profits. Therefore, a 20% return would generate fees of over $40 million. Nowadays, the largest hedge funds manage over $20 billion.

John Henry's business thrived until the period from 2003 to 2005 when commodity prices were quite cheap, and traded with little direction. Traders like Henry enjoyed success from capitalizing on major trends. As a result of the choppy market conditions, commodity funds suffered, and they were losing over 20% annually for their clients. The result was that many investors pulled their money out of these trading funds, and put their money into real estate and stocks. Of course, those markets peaked in 2006 and 2007, while commodity prices went into a new bull market.

Small investors should therefore keep these facts in mind. If a business like John W. Henry & Company can experience a very difficult period lasting years, then it is clear that the commodity futures trading business is very difficult. Small traders do have the advantage of being able to enter and exit markets more nimbly, but they face significant competition from professional trading firms that have the best intelligence. The bottom line is that most small investors should stay away from futures and forex trading.


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Scott Cole is a former hedge fund execution trader, researcher and analyst who created the website http://www.besttipsfortrading.com/">http://www.besttipsfortrading.com/> to educate traders of all levels of experience.