by Darrell Jobman

Obviously, as a speculator who is trading corn or wheat or any of the other markets, you are not going to be buying the actual physical commodity.  No, it’s much easier – and cleaner – than that.  Futures traders buy and sell “contracts” of corn or wheat or gold or whatever they’re trading.  All the transactions are made on a computer using a licensed middleman – the broker.

The specifics of the contracts include the size of the contract (e.g., how many bushels of corn make up one contract) and how the price is indicated (point value).  Each contract of a specific commodity is standardized – the same size, the same terms, etc.  If traders want to hold a larger position, they can buy multiple contracts.  If they want a smaller position, they can buy a mini contract, which is a fraction of a full-size contract, in markets that offer them.  It all depends on how much of their trading budget they want to allocate to this particular trade.

Futures contracts are only in effect for a limited period of time.  Remember, the origin of these contracts had to do with promising delivery of a commodity on a certain date.  Each futures contract specifies the date in the future when the physical commodity is due for delivery.  So, if you are trading corn, you can trade March Corn, May Corn, July Corn, September Corn, or December Corn.  These are the “contract months”.  And you specify the year of delivery.  So you can trade March 2011 Corn or March 2012 Corn.  You have to be very clear to your broker which contract of corn you want to trade.

Contracts expire as they near their delivery dates.  The exchange specifies dates when speculators must be out of their contracts so they won’t be in the market when the contract expires.  First Notice Day (FND) is the day when traders holding long contracts in a particular month should sell their positions if they want to avoid the prospect of physical delivery of the commodity.  Last Trading Day (LTD) is when traders holding short positions must buy back contracts to cover the ones they have sold.

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Let’s say you know you want to trade corn.  But which contract month do you trade?  May?  September?

You probably don’t want a contract that’s too close to the present date.  It could expire before the move you’re hoping to profit from plays out.  If it does, and you still want to stay in the market, you could “roll” into a later contract month.  But each time you do that, you have to pay fees and brokers’ commissions.  And the new contract may not be offering the exact same trade set up as the contract you were following.  So you probably want to go out a contract month or two initially to give yourself some room.

At the same time, if you go out too far in time, you may find that there aren’t as many traders in that contract.  That means the contract may not be very “liquid” – which makes it harder to get in and out of your position quickly.

So when choosing a contract to buy or sell, you probably want to be several contract months out – but not too far out.

Some futures contracts do not involve physical delivery but are cash-settled – that is, instead of exchanging a product, the terms of the contract are settled in cash by the price established by the market on a time and date specified by the contract.

The Price of Commodities

Futures traders make money because of the change of prices in commodities.  Trading is all about the price.  Prices of commodities change all day as buying and selling goes on.  Our goal is to buy at one price and sell at a higher price (or, if we’re short the market, we want to sell at a higher price, and then buy at a lower price).  That’s how we make our profit.

Determining the price of a commodity is an ongoing process that is responsible for all of the excitement of trading.  The current price of a commodity is simply an agreement between buyers and sellers – and that agreement changes from moment to moment.

In the old days, these agreements were made in the trading pits of the commodity exchanges by a process of open outcry.  Maybe you’ve seen depictions of this in movies.  Pit brokers representing buyers and sellers stand in a noisy circle, shouting, making wild hand signals, and passing notes back and forth.  As each deal is made, the price is recorded on a big board for all to see.

Those were the days, but it’s not done like that anymore.  Now it’s all done on computer.  Buyers still make bids, and sellers still ask for what they want.  But the process is all done online.  Computerized boards still indicate the minute-to-minute changing prices, which are also registered online.

But some things stay the same.  In the commodity markets, for every contract sold, there must be a contract bought.  There is always an equal number of buyers and sellers.  Trading commodities is a zero-sum game.

The determination of price is one of the most fascinating aspects of commodity trading.  It’s actually a reflection of the psychology of buyers and sellers.

Margin, Leverage, and Risk

Now we come to the main reason why commodity trading is a viable method of making money for average people.  It’s because of the tremendous “leverage” offered by this method of trading.

Here’s an example: On September 22, 2010, the closing price of December 2010 Corn was 503.5.  That means that at the end of the day of trading, with prices rising and falling throughout the session, the ending price of the day was 503.5.  Closing prices are important because, as you’ll see, we trade after the markets are closed, so we make our decisions on the closing price.

Now, at a price of 503.5, what would be the actual worth of a contract of corn?  One corn contract contains 5,000 bushels of corn.  The price of 503.5 is the number of cents per bushel corn is selling for – so on this day, corn is selling for a little over 500 cents, or $5 per bushel.  We multiply 5,000 bushels by 503.5 cents per bushel and find that the actual value of a contract of corn is $25,175.

How many traders could afford to put down $25,175 on one contract of corn?  Not many.  If that were required, there wouldn’t be any commodity markets – not like we know them today.

The fact is, traders do not have to put down the full value of a contract.  They just have to put down a small percentage of the value as a good-faith deposit.  The amount they are required to put down is popularly called the “margin” – exchanges prefer the term “performance bond” because it is like a bond that assures the terms of the contract will be fulfilled.  The size of the margin is determined by the exchange.

Aren’t you relieved to hear that?

An exchange can raise or lower the margin, usually in response to how volatile a market is.  The higher the volatility, the greater the risk, and the higher the margin.  But generally, margin is about 3 to 7 percent of the value of the futures contract.

The margin on a contract of corn September 22, 2010 was $1,283.  That means traders could control an entire contract of corn worth $25,175 with a deposit of only $1,283.

Now what does this actually mean?  You don’t really pay for your contract with the $1,283.  As I said, it’s a good-faith deposit.  When you exit your contract, if you have made a profit, you will get your deposit back, in addition to the profit.

How much profit can you make?  Well, in corn, every time the price goes up by one cent, a long trader makes $50 profit on the entire contract.  So, if the price of corn goes from 500 cents to 550 cents, this trader would make $2,500 profit (less any fees and commissions).

Is it reasonable to expect a move like that, and how long could it take?  Let’s look at a real-life example.  On June 29, 2010, corn sold for 344 cents, and on September 20, 2010 it sold for 508.25 cents.  That means that corn rose 164.25 cents – a move worth $8,212.50 – in less than three months.

Because the futures markets allow traders to control a large asset with a much smaller amount of money, we say that they offer high leverage.  Trading a high leverage instrument like this means you can make large profits with little outlay.

That can be great – except for one thing.  Leverage is a sword that cuts both ways.  Just as it allows traders to make large amounts of money fast, it can also allow them to lose large amounts of money fast.  Every time the market moves against a trader’s position (long or short) the decrease in the value of the contract is subtracted from the trader’s margin account.  If the account falls too low (below the “maintenance” amount – determined by the exchange) the traders gets a “margin call” and has to replenish his account to bring it back up to margin.  That’s why traders need to have a much bigger cushion in their trading accounts than the margin amount to cover possible worst-case scenarios.

As you can imagine, traders who aren’t paying attention and don’t get out of trades that are moving against them, can suffer big losses.  But traders who stay on top of the markets and are ready to move quickly at the first signs that things are moving against them can minimize their losses.

One way traders reduce risk is to place a “stop loss order” at the same time they place their orders to buy or sell contracts.  With a stop loss, you choose a price in the opposite direction of where you expect the market to go.  If prices do, in fact, move opposite your position, they will hit your stop price and automatically trigger your broker to get you out of your position.  This minimizes losses.

Once you’re in a position and the market is moving in your favor, you can move your stop to protect your growing profits.  This is known as “trailing” your stop, and it is something many traders do.

Another way traders reduce risk is to trade options on futures contracts, rather than trading the contract themselves.  Option trading has its own rules and vocabulary.