Commodities Risks

Dec 14, 2013   //   by Profitly   //   Market, Risks  //  Comments Off on Commodities Risks

A lot of people like to diversify their investments by finding alternative ways of trading. The large world of commodities is one way to do that. Particularly after the 2008 financial crisis, people wanted to put their hard earned cash to work in places other than equities. Corn, coffee, gold, orange juice, oil, and even cattle are different types of commodities that are traded on exchanges. This is a stark change from when commodities used to only be used for hedging, where for example farmers could ensure a certain price for their crops.

Some of these have turned out to be great investments since 2008; gold is up from $850 in January 2008 to about $1200 now. But actively trading commodities is an extremely tricky business and a lot of people don’t really understand what they are getting into.

In case you weren’t aware, most people who trade commodities lose money. A majority of the estimates are in the range of 80 to 95 percent who have lost or who are losing trading commodities. Pretty bleak statistics if you ask me. Yet, people continue to trade commodities every day and more and more people give it a try as well. Fortunately, there are several commonalities in terms of the mistakes that people make while trading commodities, meaning that if you read this and learn from it, you have far better odds of making money.

According to about.com, here are some of the most common trading mistakes:

First is lack of education. Just like I said above, a lot of people don’t know what they are getting into when they start trading commodities. This is just like people that try to trade penny stocks without learning from Tim or the other gurus. Sure, even without education you will get lucky and have a good trade or two, but the odds are not in your favor. Far too many new traders neglect to educate themselves on how to trade commodities before diving in head first. Commodities is a zero sum game, meaning for every person that makes $100, another person lost $100.

Second we have the leverage problem. This is probably the number one issue when it comes to trading commodities. There is huge leverage when trading commodity futures, so a couple bad trades can wipeout the over leveraged trader. Do not trade a contract that is too large for your account size. For instance, do not trade three futures contracts that average a $2,000 move a day when you have a $10,000 account.

Third we have money management. This is another biggie and relates to the tip we previously discussed regarding leverage. You should not risk more than a small percentage on any given trade. There are statistics showing that most professional money managers risk less than 2 percent on any one trade. This becomes more difficult when trading commodities and other futures contracts.

Finally, remember to have a plan. How many times have Tim and I written about having a PLAN before making a trade?! Traders get so lazy and impatient when it comes to this. You have to have a plan.

So now that you have that advice, let move in to the elevated risks of trading commodities. You can’t help but think about risk when you think about trading commodities.

The key reason why commodities are considered risky is that commodities are traded in futures contracts and they are highly leveraged (addressed in the four tips above). A commodities trader normally only has to put up 5 to 20 percent of the contract in futures margin value to control the commodity investment. When you buy one contract of crude oil, you aren’t just buying one barrel, unlike when you buy a stock, you can buy one stock. You are actually buying 1,000 barrels of crude oil when you purchase one contract. That means in crude oil is trading at $90 a barrel, you are buying $90,000 worth of oil, not $90. However, a trader doesn’t need to put up the full $90,000. They would be required to put up a much smaller percentage, around $6,000 in this case. This also means that if oil moves from $90 a barrel to $89, the value of your position would change by $1,000. That’s leverage since you don’t have to put up the full amount. How do you feel about entering a commodity trade with $5,100 in margin and realize that position can move for or against you by about 40 percent every day?

The fact that uneducated traders do this without even realizing what they are getting themselves into is very, very scary. This kind of leverage in the hands of an undisciplined trader is the reason so many new commodity traders lose money. It is commonly discussed in the futures industry that anywhere from 80 to 95 percent of traders lose money in commodities, slightly more than the average number of people that lose money trading stocks. Those educated in trading commodities, such as commodity trading advisors (CTA’s) have a much better track record with managed futures. The popular Barclay CTA Index has CTA’s making an average compound annual return of 11.56% from 1980 to 2009. There were only 3 losing years and the worst was -1.19%.