Investing Guides: Commodity Futures

The Commodity Futures Market is probably the riskiest, most volital, of the markets. Knowing the risk and the work involved will determine whether or not its the market for you.

As you work your way through the basics of investing, you'll find some segments of the market harder than others. If you've come across Commodity Futures & Options, you know what I'm talking about. This is arguably one of the most complex and risky parts of the investment world. Still, more than 1 billion futures and options contracts are traded on the U.S. Futures Exchange, so somebody likes it. If you're interested in finding out whether or not Commodity Futures & Options should be a part of your investment portfolio, here is a basic rundown; mere pointers to get your hands around definitions and purposes.

Commodity Futures are traded on special markets with Chicago being the town of choice. The Chicago Board Options Exchange, The Chicago Board of Trade and The Chicago Mercantile Exchange (the largest) are a few. Futures trading isn't the latest trend in the investment world; far from it. It dates back to Chicago with grain dealers in the middle of the 19th century. Have you ever watched the network that shows the men and a few women in horribly colored jackets yelling and screaming while they wave their arms around frantically? Those are windy city floor traders in the futures market, and what looks like a chaotic mob revolt to the rest of us is a natural day for them.

Commodity Futures and Options are not the same as stocks; meaning they are not equity. They are basically contracts for future delivery, at a locked in price, of a wide range of products from soybean and pork bellies to oil and gas. Only not onions; don't ask me why. For some reason, onions got bumped from the list. The contract is a legally binding agreement between the buyer and seller on a price and amount to be delivered or paid for on a settlement date, determined by both. The buyer pays a market determined price (premium) and has the right to exercise his or her option within a specific time period. If you're thinking this sounds something like the stock options your employer gave you, you're in the same state, just not quite there yet.

To simplify it as much as it can be, it's like your neighbor has an apple tree with a finite amount of apples that ripen every summer. You don't want to wait until they ripen in a few months because they may cost much more than they do now. So, you offer your neighbor a certain price that is just a little more than they do now for a certain amount of apples. She agrees to deliver the apples to you the second they are ripe. That's your futures contract.

Why would you operate in the futures market? It's defiantly more complicated, but with the risk involved in products known for volatile pricing like oil or grain, it's a safety precaution. What if only half of your neighbor's tree ripens? She'll have to double the price of apples to make the money she needs. Where does that put you if you wait until then to buy them? Yes, it's all risky; probably the riskiest type of trading out there, but has its purposes.

Why would your neighbor operate in the futures market? She takes the risk of making less than double on a bad crop in exchange for the chance to profit on a good crop. This is referred to as hedging, a term you'll hear a lot in the futures market. It's simply insurance against the damages of price volatility.

Futures Trading works similar to stock trading because the profit and loss results from price changes reliant on the market of consumer supply and demand. Let's say you contracted with a beef seller at a .50cents a pound for beef the year before Atkins became a religion. Based on demand, beef prices went up as did milk, eggs and all that heavy protein stuff. You can make a good profit when you sell that beef at $2.00 a pound, the market demand price.

Enough with all the good news about buying low and selling high. This market is risky and if the price goes in the opposite direction, you can lose big. You could lose the chance of profits and even lose the chance the breaking even. Because the contract is usually insured, the buyer can lose the premium and associated costs, but the seller can lose much more.

To put a wrench into this lesson, you need to get one more thing. The buying and selling of these commodities hardly ever happens. There are a lot of players in this market that are in it for the market itself; not the goods. Many buyers have no intention of taking delivery and many sellers have no intention a making delivery of the product. They just want to profit from the change in price. They're called speculative investors and their presence keeps the market competitive.

You can choose to trade in this market by yourself after you've cleared through a registered broker licensed for that particular market. Be cautious and don't assume because you know the Stock Market or the Fixed Income Market, the Futures Market will just fall in line. Make sure you call the National Futures Association at 1-800-676-4632 to get all the basic information on the market and find out, if you plan to hire a broker, if any disciplinary action has been taken against him/her.

Before you decided how you want to play you have to ask yourself this"¦How much do I want to be involved in trading on this market and do I have the time to commit to that? There is the trading, research, tracking, administrative task, regulations and rules, keeping abreast of fraud alerts and following the glossary. This market has a vocabulary all its own so don't think you're knowledge of stock market terms will get you through this.

Generally, the desire to diversify is what attracts one to the futures market as well as the chance to reap a higher rate of return in exchange for the greater risk. Gains and losses are tallied every day, deposited in or debited from accounts immediately. The government's Commodity Futures Trading Commission has an entire website devoted to this sector with its sole purpose to serve as an educational tool and protection for investors from fraud, manipulation and abusive practices. It might be a good place to start.

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