Busting the Myths Associated With Commodity Trading

Feb 15, 2021 08:21 PM ET
Busting the Myths Associated With Commodity Trading

There is a general notion within the trading community that it is too difficult to earn profits by trading in commodities. But, this notion is created by traders who fail to maneuver efficiently through the market, thus incurring losses. Truth is, there are several individuals who have experienced success through trading commodities, so we must analyze these myths in order to clear the misconceptions.

The excess leverage problem

Leverage is the major roadblock for most individuals as far as commodity trading is concerned. For a futures margin, you need to spend around 3-15% of the total amount in the futures contract. Compared to stocks, commodities thus have a much lower rate.

Inexperienced traders find it difficult to deal with the leverage, but the fact of the matter is that the volatility of commodities is lower than stocks if you don’t consider leverage. Thus, several traders dealing with commodities mistakenly invest in more future contracts than what’s required. This leads to them losing money when the commodity’s value diminishes. 

Thus, to become a successful commodity trader, you should purchase fewer contracts than what’s specified in the margin requirements. This can successfully factor out the excess leverage aspect that makes commodity traders wary.

Too much volatility

crude oil

If you ask a random trader what's the biggest problem in commodity trading, they will probably mention volatility. While stock prices can shift by 20% during a particular trading session, the contracts for commodities like energy and metal can fluctuate by 6% in a single session. For agricultural commodities, the prices can shift by 4% at most. 

Some of the most popular commodities, such as base metals, energy counters, and precious metals are greatly affected by price movements in the global market. But, since the trading goes on for extended periods of time, you have the opportunity to capitulate on the price action. 

To debunk this myth, you need to avoid overtrading. While it is true that you can double your profits if the value of commodities rises, you can also exhaust your capital if the price drops. 

Heavy margin requirements

Heavy margin requirements

This is one of the most popular myths surrounding the commodities market, and it often stops individuals from placing their trades. While trading in commodity futures, the margin requirements are usually around 4-5% of the contract’s net value. 

These days, there are mini contracts available for some of the most popular commodities. This has lowered the margin requirements, so there is no reason why you should shy away from commodity trading. When options are available, the capital reduces and can be locked in considerably; this should encourage retail investors. 

Hard to make money

It should be kept in mind that commodity trading is a risky affair, and losses do occur from time to time. Nevertheless, people suffering from huge losses are mostly inexperienced traders who jump in without adequate preparation. This leads to their accounts getting exhausted in a matter of months, and they never see their money again. 

Meanwhile, there are other people who get addicted to trading in commodities and keep placing consecutive trades using the same age-old schemes, even after suffering back to back losses. One positive thing about the commodities market is that when one person loses money, another person ends up gaining it. If you consider transaction costs, then the loss suffered by the first trader is a bit more than what is gained by the second one.

This raises the question, who are the people making gains through commodity trading? Usually, it is the money managers and traders who make profits on a consistent basis. For an amateur investor in the commodities market, taking profits may take more than 30 years. 

Those who are successful in commodity trading generally trade in larger amounts. An expert trader with $2 million can make gains of $400,000 every year, and they come from unsuccessful traders who suffered heavy losses. These traders have solid plans in place that allow them to trade in commodities in an efficient manner.

Commodity delivery

Commodity delivery

There is a common misconception that deliveries must be taken by every commodity trader. This is absolutely not true as mandatory deliveries only exist for several specific commodities, provided the positions are kept open following the end of the notice period. In general, individual investors should not lose sleep over taking deliveries. 

For some commodities like gold and copper, delivery is made compulsory. Nevertheless, you don’t have to take deliveries for metals and crude oils since the transactions are settled through cash. Cash settlement is the process of paying the price difference to settle a futures contract as opposed to taking delivery.

You should ensure, however, that you close the futures contract before the first notice that comes a few weeks before the contract expires. In case you forget to do so, it is likely that your broker will get in touch with you and warn you about further notices.

Lack of information

The prices in the commodity markets change depending on currency market movements, international economic events, demand and supply conditions, etc. Thus, you can get a whole lot of information concerning commodities like base metals, oil, and gold from various news sources. The majority of the brokers with commodity trading facilities provide you with regular market updates and research, thus supporting the commodity traders’ community.

Summing up

As alternative sources of investment are becoming more and more popular, traders are prompted to experiment with various financial avenues. Commodity transactions are easy to carry out, and they offer high liquidity, so all of the popular brokers allow their clients to trade in commodities. As discussed, most of the myths surrounding this market are false, but you should carry out thorough research and formulate efficient plans in order to gain success.

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