A Traders First Book on Commodities
My aim has always been to provide readers with a candid account of the realities of trading rather than fill them with unrealistic expectations. I believe that doing so can better prepare traders for what lies ahead and, accordingly, might improve their odds of becoming a victorious trader. Throughout this book, I have outlined the difficulties of trading, but hopefully, I haven’t discouraged you from involving yourself in the commodity markets. After all, the futures and options markets can be potentially lucrative for those willing to accept and properly manage the corresponding risks. Furthermore, I am a broker who makes a living through the commission earned as my clients trade commodities. The last thing that I want to do is deter qualified parties from the futures markets. However, it is important that I encourage traders to come to futures and options for the right reasons and certify they know what to expect when they get there.
Regardless of what your impression has been up to this point, let it be known that, along with the significant risk of loss involved in futures trading, there is potential for momentous profits. Substantial profit potential is why speculators flock to the markets and it is what keeps them coming back—even if they didn’t achieve what they were looking for the first time around.
There is a lot of money to be made, or lost, in all markets, but for those with the willingness and the capital to speculate, the futures and options on futures markets offer some glaring advantages over other vehicles.
Unfortunately, at times to their peril, humans tend to gravitate to what they are more familiar with. As we all know, in many cases, convenience and ease might not necessarily be the optimal choice. I believe that the same can be said of the option that speculators have in participating in either the equity markets or the commodity markets.
Horror stories circulating about large losses suffered by commodity traders and the forced delivery of 5,000 bushels of corn have kept the futures market a dark mystery for many retail traders. However, losses are possible in any trading environment, and well-organized traders utilizing proficient commodity brokers don’t have to worry about the hassles of the delivery process. I don’t think it is fair to blame the trading venue for life-ruining outcomes; more accurately, it is often the fault of market participants themselves. As discussed in Chapter 1, “A Crash Course in Commodities,” traders choose how much leverage to employ in their strategy and which markets to participate in. Sharp losses at the hands of undercapitalized trading accounts, over-active trading, or a sheer gambling can only be attributed to one party—the trader. That said, participating in the futures and options markets requires an additional amount of self-control due to easily accessible leverage and 23-hour trading sessions. If you can’t control yourself while surrounded by the temptations of flashing lights and promises of big payouts in a casino, you probably won’t be successful in the commodity markets either.
In this discussion, we focus on the most popular stock index futures contract, the E-mini S&P 500, in comparison to trading stock index ETFs (exchange traded funds), but similar principles apply to all commodities. For instance, for those speculating on the price of gold, ignoring cash market options such as bullion, they have the choice to use a gold ETF, the stock of a gold mining company, or they can trade gold futures contracts. Similar stock and ETF opportunities exist for corn, soybeans, and most other commodities. Each choice can potentially enable traders to profit from correct predictions in the price of the underlying commodity—and lose if they are incorrect—but there are inherent advantages to trading futures over stocks that shouldn’t be ignored. In addition, ETFs or stocks that are correlated to a commodity such as GLD, CORN, WEET, and USO are likely not perfectly correlated, and this creates a less efficient means of speculating on the price of a given commodity. In fact, due to ETF rebalancing and the costs involved in rolling over futures contracts within the fund, it is possible for ETF buyers to miss out on profits despite correct speculation in the underlying asset itself. Even worse, those with incorrect predictions of a commodity price playing their hunch with ETFs will likely suffer larger losses in the ETF than they would have by speculating directly on the commodity price in the futures market (ignoring leverage, of course). In other words, the ETF price doesn’t always track the asset price it is intended to.
Some people might say leverage is a reason you should not trade futures because it can work for you as well as against you. As you must realize by now, the use of leverage supercharges profits in accurate trades but has the potential to create dramatic losses for those on the wrong side of a market move. Naturally, the amount of leverage—and, thus, position volatility—is highly dependent on the market being traded and the strategy used. Moreover, traders can reduce leverage altogether by depositing the full value of the futures contract rather than the minimum margin required by the exchange or the broker. Specifically, although the exchange sets a minimum overnight margin requirement, the trader decides how much leverage to use through account funding and position size.
Throughout this book, I have noted that most futures brokers and brokerage firms offer relatively lenient day-trading margins, in addition to stringent yet generous overnight margins. At some firms, you can day trade a single E-mini futures contract with as little as a $500 margin requirement. That said, just because it is possible to buy 20 E-mini S&P futures in a $10,000 account doesn’t mean that it should be done. In fact, doing so would equate to the trader making or losing $1,000 per point of price movement in the futures market, or 10% of the trading account, on a small price move. On the other hand, futures margins are flexible; with the S&P valued at 2,300, an E-mini trader can eliminate the leverage provided in the futures markets by depositing $115,000 (2,300 × $50) and trading a single contract. Obviously, there’s a big difference between day trading on a $500 margin and fully funding an account with $115,000 in deposited margin per contract traded. This is a great depiction of how much control the trader has over leverage, and how the temptation of leverage has the power to control traders.
To put the leverage of trading commodities into perspective, consider an example. I have seen a long-option-only account go from a net liquidation value of $10,000 up to an intraday value of nearly $500,000 in a matter of weeks. Unfortunately, I witnessed the same account eventually give back all the profits, plus a lot more. The circumstances surrounding this incredible rise and fall are unique: It occurred during one of the biggest stock-market plummets of all time. I am sure the 2008 crash will be etched forever in the minds of those who let riches slip through their hands. However, the point is that aggressive traders can potentially make or lose life-changing amounts of money. Of course, not everybody is willing to lay so much on the line—nor should they be. Still, the potential is there for those who want to spin the roulette wheel.
On the other hand, I have worked with clients who, after years of familiarizing themselves with the markets, found a way to make a comfortable living trading futures and options on futures. It didn’t happen overnight, and I can guarantee that they weren’t quick to quit their day jobs. But after putting in adequate time and paying their dues in the form of expensive market experience, they are now living the dream. I can assure you that these types of traders are approaching the markets in a more conservative way than those looking for a get-rich-quick solution to their problems; nonetheless, easy access to leverage might have played a part in their triumph.
Conversely, stock traders are not allowed to use margin—well, at least not without paying for it. For a stock market speculator to buy a greater number of shares than she has money for (trade using leverage), she must first apply for a leverage account and then pay her brokerage firm a fee for the funds borrowed. The costs associated with using leverage can be substantial and simply make it more difficult for a speculator to trade profitably. Similarly, most stock brokerage firms require a rather large trading account balances to qualify for margined (leveraged) trading. Many approve margin accounts only for clients with more than $100,000 on deposit. Others approve the use of leverage but charge higher rates of interest or margin for accounts of less than six figures. Conversely, all futures accounts are granted cost-free leverage, regardless of account balance. To give you an idea of how favorable trading on leverage in the futures markets relative to equities can be, a commodity trader with $1,000 is treated the same in regard to the margin as a stock trader required to deposit $100,000 would be in the equity arena.
As I have pointed out throughout this text, it is important to speculate in liquid commodity markets. There are a handful of futures contracts that simply don’t have enough market activity to enable seamless entry and exit; these contracts should generally be avoided. However, the major commodities such as oil, natural gas, gold, silver, corn, soybeans, wheat, Treasuries, and stock index futures trade electronically in high volumes and with narrow bid/ask spreads nearly around the clock. On the contrary, many commodity ETFs and equity stock index products, particularly leveraged securities, are illiquid. Further, they do not trade overnight; speculation can only take place during traditional stock market hours.
To summarize, futures traders can easily enter and exit the market with minimal transaction costs and acceptable amounts of slippage in fill price nearly 24 hours per day. The price paid for executing a lightly traded ETF can be substantial and can only be done for about seven hours per day.
As a trader, it is imperative that you fully understand the consequences of trading in markets that have few participants and, even more important, that you do your homework on each product that you are interested in trading. This is true regardless of the trading arena chosen.
One of the most compelling arguments for futures trading relative to stocks or ETFs is the ability to quickly and efficiently sell a contract in anticipation of the market going lower. In the world of commodity trading, this is the case regardless of market circumstances or account size. The idea is to buy back the contract at a better (lower) price at some point in the future. Of course, things don’t always work out as planned, and a short trader may be forced to buy back the contract at a loss (higher price). Nevertheless, the convenience of speculating in both directions with the click of a mouse and the absence of interest charges is unique to the futures markets.
An equity trader can also sell shares short, with the intention of buying them back at some point in the future. Nevertheless, to do this, he must first borrow the shares from his brokerage firm and pay interest charges accordingly. In addition, the stock broker must have shares on inventory to loan to traders who want to short them. This is much less expedient and more costly. Once again, stock brokers typically require an account with tens of thousands or hundreds of thousands of dollars to grant traders the same leverage privileges that futures traders receive without stipulations. Futures traders enjoy the simplicity of buying or selling without hassles; their only concern is accurate speculation.
Before equity traders can sell shares with the intention of buying them back at a lower price or trade with leverage by spending more money on shares than they have on deposit, they must qualify for a margin account. The process of opening a margin account involves slightly more paperwork and a quick background and credit check by the brokerage firm. In futures, all accounts are opened on margin; additional paperwork and aggravations are not necessary. Nonetheless, a background and credit check are standard among futures brokerages, to prevent money laundering and ensure that futures traders are financially equipped to accept the risk of participating in such markets. After all, when trading on leverage in a margin account, traders are essentially being granted credit. Thus, the process of opening a commodity trading account is similar to applying for a credit card or small loan.
In addition to the supplementary barriers to entry for a margined stock account, most stock brokerage firms will not approve a margin account application for clients with less than $50,000—and they may require far more. On the other hand, some futures brokers allow clients to day trade the E-mini S&P with initial funding balances as little as $2,000. In addition, long commodity option traders face limited risk and are often free to open accounts with even smaller balances. Of course, an ultra-small trading account might not provide an ample number of opportunities, but it is nice to know it is possible.
As if the time delay and restrictions of borrowing shares in addition to the obstacle of large account minimums weren’t enough of an argument for futures market speculation relative to stocks, equity brokerage firms typically charge interest on margined positions. Such a trade might also incur additional transaction fees. Conversely, futures and options on futures traders are not expected to pay interest on leveraged trading activity. The exchanges and the corresponding brokerage firms provide the leverage free of charge. Simply put, for a stock trader to turn a profit on a short position, he must first be right enough in the direction to overcome the interest charges paid to the brokerage firm in return for borrowing shares. Yet, a futures trader’s breakeven point is dependent merely on the transaction cost of a few dollars.
I argue that all else being equal, similarly skilled traders utilizing an identical strategy in similar products yet two alternative arenas—stocks and futures—might see superior results in the futures trading account due to a lack of interest payments.
With that in mind, it is also important to point out that futures contracts do not pay dividends as some stocks and ETFs might. These dividends work in favor of speculators long shares, but those who have borrowed shares from their brokerage to short a stock must pay the dividend to the buyer of that stock!
Futures contracts are generally filled on a first-come, first-served basis, with little or no human intervention. This wasn’t necessarily the case when open outcry was the primary method of execution. The idea behind the creation of the futures exchange’s electronic platforms is to provide an arena in which a trader executing 1,000 contracts at a time and one that is trading a single lot will be treated the same in terms of execution. On the other hand, this might not be true in venues that involve market makers, such as equities, ETFs, and open outcry executed commodity options.
In general, profitable equity traders face a much larger tax burden than commodity traders do. In addition, the process of claiming trading profits and losses at the end of the year is much simpler for a futures trader than one who is actively trading equities.
The IRS requires equity traders to list each transaction and the net result of each trade. You can imagine the frustration involved for day traders. However, on a brighter note, it encourages a daily trading log and can make it easier for equity traders to look at their results realistically.
Futures traders, on the other hand, report a lump-sum profit or loss figure on a 1099 at the end of the year. The 1099 displays the performance of the trading account net of commissions and fees, accounting for deposits and withdrawals. In essence, your futures broker takes on the burden of figuring out the math; all you and your accountant need to do is input the final number on Form 6781 in your tax return.
However, the tax benefits of speculating in a futures account, compared to a stock account, don’t end in convenience; there are substantial monetary advantages as well. All futures, and options on futures, market gains are taxed at a 40%/60% blend between long- and short-term capital gains, regardless of the time span of the trade. Because long-term capital gains are taxed at a more favorable rate than short-term gains, assuming that they are profitable, futures market speculators enjoy a considerable tax break relative to stock traders.
Let’s face it, commodity trading is exciting and unpredictable. Not only is it somewhat mysterious to the common investor, but at times it also can change the lives of market participants. I have seen call options in sugar bought for $200 grow to values in the several thousands. I have also witnessed a trader take an account from approximately $250,000 to more than $4 million and then back down to eventually produce a negative balance! Of course, these examples are the exception rather than the rule, but the point is that nearly anything is possible.
I have come in contact with futures traders who have yet to find a way to consistently make the amount of money in their trading ventures needed to justify the time spent, but simply yearn for the adrenaline rush; that is enough to keep them coming back for more.
I could never recommend that traders come to commodities solely for entertainment because that type of attitude will likely lead to substantial losses resulting from unnecessary risks taken. Nonetheless, I cannot deny that this is one of the most compelling reasons that traders venture into futures and options. In fact, from more than one avid commodity trader, I have heard stock trading compared to watching paint dry. Keep in mind, however, that I am referring specifically to speculation, not investing—there is a big difference between the two forms of market participation.
Most of the contracts of interest to speculators and listed by the futures and options markets have been traded for decades and have an ample amount of liquidity. On the other hand, many of the commodity ETFs that speculators use to wager on the direction of crude oil, soybeans, Treasuries, the VIX, or other commodities were brought to existence in recent years as a result of the commodity boom and attempts at Wall Street to retain the business of commodity speculation. Unfortunately, with the financial collapse of the late 2000s, many of the newly listed ETFs were forced to cease operations due to a lack of interest. Although ETFs are growing in popularity in regards to money flow, there are a substantial number of ETFs in existence with dismal trading volume and perhaps a limited life. Although investors in delisted ETFs do get their money back, this can be a significant speed bump in the progress of their speculative plays.
Another strike against trading ETFs is the so-called “short” or “ultrashort” products that are designed to mimic the return of being short an asset or index. In many cases, due to the way the fund tracks the daily fluctuation of the asset it is intended to mock, the performance of the ETF will match underlying assets on a short-term basis, such as one day or two. Traders hoping to buy and hold the ETF might find themselves in a situation in which they were right about the market direction but incurred a loss because of the way the ETF rebalanced. Most agree that short or ultra short (leveraged) ETFs are designed to be a day trading vehicle and should not be considered an effective way of speculating in time frames beyond of a few days.
In my opinion, ETF versions of long or short commodity markets are extremely inefficient. Those who are truly interested in playing in the commodity markets should do so in the futures markets, where it is the real deal.
I would never advocate allocating a major portion of any retirement account to commodity trading. However, so few traders even realize that this is an option that I felt obligated to mention it. As you can imagine, there are definite tax benefits to trading funds earmarked for futures speculation in a retirement account. Specifically, tax-deferred or tax-free growth is possible depending on the type of qualified IRA (individual retirement account); rollover 401(k)s are also candidates for futures trading. In theory, trading accounts within the shelter of a tax-friendly IRA have the potential to grow at much more rapid speeds compared to those in a nonqualified account (outside the IRA umbrella).
Of course, only profitable traders enjoy the advantages of an IRA. For those less fortunate in the markets, trading within an IRA can become a burden: Losses are not tax-deductible as they would be in a nonqualified account. Similarly, trading futures within an IRA typically involves incremental fees paid to an account custodian, which can slightly exaggerate trading losses or reduce gains.
There are diversification arguments in favor of allotting 10% to 20% of retirement account savings to managed futures programs, algorithmic trading systems, or even discretionary trading for those with ample experience. I personally trade a small IRA account as a mix to a traditional stock and bond portfolio.
As this chapter has outlined, there are many reasons to trade futures, but there are also reasons not to. In a few cases, the same arguments for speculating in commodities are the reasons that attract speculators—and capital—to the futures markets that shouldn’t be there.
Regardless of your intentions or vehicle in speculation, one common rule persists: Never trade money that you can’t afford to lose. If you are like me, it seems that there’s no such thing as money that can be lost without some type of anguish. Nonetheless, risk capital is defined as an amount of money that, if lost, would not alter your current lifestyle. Even those who trade for a living will have bad days; it is important that they don’t let a bad day, week, or month turn into ruin. A good way to ensure this is by limiting trading accounts to expendable funds.
Each trading account opened by a brokerage firm undergoes some scrutiny in terms of an applicant’s net worth, income, and bankruptcy history, if any. Most commodity firms require that applicants have a net worth of at least $20,000 and a minimum annual income of $20,000 but there aren’t any black-and-white limits. Each application is taken on a case-by-case basis. The reasoning behind the policy is twofold: First, sufficient income and net worth confirms that a trader could, or should, have some risk capital to allocate to the treacherous game of speculation. Also, as you should realize by now, futures traders can lose more money than they have on deposit in their trading accounts. Accordingly, brokerage firms must determine whether the risk posed by clients who might lose more money than they can pay back is worth the reward of accepting them as clients of the firm.
Yet despite attempts of brokerage firms to prevent traders from trading with money that, if lost, might cause significant changes in their financial well-being, such capital manages to find its way into the marketplace anyway. Unfortunately, those doing so are opening the door to financial hardships, ruined marriages, or worse. Again, the commodity markets are often blamed for negative outcomes, but it is the participants who generally bring it upon themselves. Whether you are actively trading equities, futures, or options on futures, it is important that you realize that speculation is a risk, not an investment; only risk capital should be used.
The commodity markets provide speculative opportunities that other markets simply can’t offer. In my opinion, the convenience of gaining leverage and the ability to quickly buy and sell trading instruments in any order creates an extremely efficient, and unbeatable, means of betting on anticipated price changes. Also, the tax benefits of profitable speculation in commodities, as compared to equities, are dramatic and can potentially have a profound impact on the overall results. For these reasons, those who fully understand speculation and are willing to accept the risks associated with it should strongly consider doing so in the futures and options markets.
As I have noted, speculation itself is a difficult task to master. In fact, some of the most successful traders report account-draining losses on numerous occasions before gaining the experience needed to be among the estimated 20% of profitable traders. However, despite the challenge, achievement is possible, and under the right circumstances, life-changing profits can happen.
This is an excerpt from the third edition of A Trader’s First Book on Commodities (October 2017) written by Carley Garner, an experienced futures and options broker with www.DeCarleyTrading.com.