If you are new to trading and you are interested in knowing more about the basics of futures trading then you will want to learn as much as you can. The first thing you need to know is what futures trading means.
Futures Trading in simple terms is an investment where you try guess whether the price of a commodity is going to go up or down some time in the future.
The next thing you should know is what a commodity is? A commodity is a product or a good that many people use each day. Here are some examples of a commodity:
- food fibers and grains
- meat and animals meant for food
- a few miscellaneous items such as wool and rubber
- currency (money from all around the world)
There are many more commodities but for the purpose of keeping futures trading simple, just keep in mind that these products or commodities are traded between companies every day in many different countries in the world. Each company that trades commodities has two major things in mind. They either want to make profits as a result of their trades or they want to minimize risk. This risk management is where a new futures trader or commodities trader can make money if you are prepared for all of the hard work and learning that must take place before you even think of making a real trade!
When companies buy and purchase commodities, they actually purchase the physical goods on one day and they set up a delivery date for another day at a later time. This locks in the price for them. The way they are able to lock in these prices is through investors paying the difference in whether the commodity price goes up or down.
Commodity Futures Trading For Beginners (How it works)
If you are a beginner and you want to learn about trading commodities, don’t worry – You do not have to actually buy 1000 barrels of oil and store it in your yard! While that is what the companies do, as an investor you are merely trading on price fluctuations. You do all of your trading on a computer screen that essentially has futures and commodities trading software integrated into a server so you can trade right from the comfort of your own home. Thus, commodities trading for beginners can be made more simple by studying and learning about various futures trading software and commodity trading software.
What is being traded in futures and commodity trading?
You actually trade futures contracts so no real product is ever exchanged. The trade occurs online through an exchange. An exchange is a trusted place where people can trade future contracts. The contract states the intent of the parties involved to buy specific quantities of a commodity at a specified price with delivery set at a specific time in the future. Even though the traders do not physically store the products and trade them there is real money involved so use extreme caution before you attempt a futures trade or a commodity trade.
Think of it as a casino where many people bet a day with poker chips. Some bettors win and cash their poker chips in at the end of the day and some lose and go home with less money than they started with. The only difference is that rather than gambling on cards they are “invested” in guessing what the price of a commodity will be and they use contracts to specify a day, price and time at which they will trade.
Things you Need to Know about Futures Contracts
- Futures contracts are agreemenst traded on an exchange to buy or sell assets, commodities, or shares, at a fixed price but to be delivered and paid for at another time.
- Futures contracts have an expiration date. However, you do not have to keep your contract until it expires so you can cancel your agreement when you want to.
- The expiration dates are different depending on the type of commodity you choose so it is important that you choose the one that is right for you.
- In general the closer you get to the expiration date, the more traders it tends to draw. Think of it in terms of an online auction. The closer you get to the end of the auction the more people tend to start bidding.
- You can trade as many times as you want and can trade as many contracts as you can afford or are willing to risk.
- There is a system of checks and balances that makes sure the products are traded at a standard size weight, quantity etc. so everybody is aware of what exactly is being traded. For example, a crude oil futures contract holds a specific amount of barrels of a certain quality so people know they are not being cheated.
- There are fees that your broker will charge you for a futures trade so pay attention to how much they are going to charge you based on your specific contract.
To make futures contracts easier to understand let’s look at a made up example.
Example of How Futures Work and How Future Contracts Get Started
Imagine that Aardvark’s Pizza Shop uses tomatoes from a farmer across the street known as “Farmer Joe”. Farmer Joe has a good year and grows more tomatoes than he ever felt possible. Next, Farmer Joe ends up with a surplus so he lowers the price of his tomatoes in fear that they will all go bad before he can sell them all. Aardvarks Pizza’s profits start to shoot through the roof because they are getting a great deal on tomatoes. However, Farmer Joe ends up losing money because nobody in town wants any more tomatoes. Eventually, Farmer Joe gets stuck with a bunch of rotten tomatoes and he has to hire extra help to dispose of all the rotten tomatoes. Thus, he loses even more money.
The next year a stink bug epidemic eats all the tomatoes in the world except for a select few which Farmer Joe keeps safe in his greenhouse. What happens next is a bidding war takes place for his tomatoes and Aardvarks Pizza has no choice but to pay insane prices to Farmer Joe. In this case, Farmer Joe makes a ton of money but Aardvark’s Pizza nearly goes bankrupt.
Frustrated by the dependency on how well tomatoes grow and the ever changing price Farmer Joe and Aarvark’s Pizza come up with a plan. They each decide to make a contract setting the price at an amount that seems fair to them both. They both agree that the price of tomatoes must now be exactly $2 a pound so they seek out 2 investors to cover the difference should the prices change.
“Investor A” deals exclusively with Farmer Joe. He and Joe come up with a Future’s Contract. The contract states that if the price of tomatoes goes below $2 a pound then Investor A will pay Farmer Joe the difference. If however the price of tomatoes goes over $2 a pound than Farmer Joe will pay the investor the difference over $2 per pound.
On the opposite side “Investor B” makes a deal with Aardvarks. If the price of tomatoes goes over $2 a pound the investor must pay Aardvarks the difference. If the price goes under $2 a pound then Aardvarks still has to pay investor B $2 a pound so the more the price drops the more investor B is rewarded.
Here is a diagram that will help you understand how this works:
I hope that this basic introduction has made commodity and futures trading easier to understand for beginners. Let’s face it, futures trading is for advanced traders with an uncanny ability to guess the future price of commodities at an exact time. It is not easy. For most traders, it is something best left to the experts but for those that wish to learn more there is a great deal of information out there to learn more about commodities investing for beginners.
If you would like to comment below or have any input that would make understanding futures contracts and understanding commodities trading easier please do so. After all, it is my goal that we all work together to educate one another on how to become better traders. I find this to be especially important when covering complex topics such as futures and commodities. Also, if anyone would like to share some basic futures trading strategies please do so since we will be covering that later on down the road.