Commodity Futures Trading for Beginners

By Bruce Babcock

The Trading Process

Here are some typical steps in the process of making a commodity trade including the trader's
decision-making process and the procedures involved in actually placing the trade.

In order to make decisions about when to trade commodity futures, you must have a source of price data. Many daily newspapers carry some commodity prices in their financial sections. The Wall Street Journal has comprehensive commodity price listings. Investor's Business Daily has both price tables and numerous price charts.

All experienced commodity traders prefer to look at price activity on a chart rather than trying to interpret tables of numbers. In financial analysis, charts are indispensable for quickly grasping the essence of historical and recent price action.

The typical commodity chart depicts daily price action as a thin vertical bar which indicates the day's high and low by the top and bottom of the bar. The opening and closing prices are shown as tiny dots attached to the left and right side of the bar. A typical daily price chart can show up to six months of price action this way.

It is easy to change the bar's time frame from days to weeks or months and thus show from two to twenty years of historical price action in the same format. For short-term trading you can change the bar's time frame to hours or even minutes.

Looking at such bar charts enables a trader to see the recent trend of prices--whether up, down or sideways--in whatever time frame he chooses. Following the current trend of prices is a cornerstone of
successful trading.

There are a number of ways to obtain the price charts a trader needs to analyze the markets. You can make your own using graph paper. This sounds rather primitive, but some experts recommend it as a good way to put yourself in close touch with price activity and monitor risk.

Another source of charts is the printed chart service. There are about half a dozen of these. They typically mail a booklet of numerous charts covering all the tradeable markets after the markets close on Friday. There is space on the charts to update them daily during the following week until next chart book arrives. These printed chart books normally have a number of indicators plotted along with the price action and contain a wealth of additional information.

For computer owners there are many software programs that create fancy charts on the computer screen. You can input the price data manually or, via telephone modem, download comprehensive data after the markets close for the day. Those with larger budgets can install a small satellite dish and watch price changes in all the markets nearly instantaneously as they occur. The software creates charts dynamically on the computer screen as each trade takes place on the exchanges. You can put many different charts on the screen and thus watch numerous markets all around the world in real time. The cost can range from a few hundred to $1,000 a month depending on the software and the number of exchanges you subscribe to.

It is easy to believe that computers can make a big difference in trading success. Vendors of expensive software will tell you that since other traders, who are your competition, have expensive computer setups, you need one too. This isn't really true. Those who can't trade profitably without a computer probably won't be helped too much by using a computer. It may actually be detrimental by causing an increase in trading frequency. While a computer will not make a bad trader into good one, they are fun to use, and they do make a trader's life easier.

There are two primary analytic methods for deciding when to take a futures position: fundamental analysis and technical analysis. Fundamental analysis involves using economic data relating to supply and demand to forecast likely future price action. Technical analysis involves analyzing past price action of the market itself to forecast the likely future price action.

While there are differences of opinion about the relative merits of the two approaches, almost all successful traders emphasize technical analysis. There are a number of reasons for this. First and foremost is the difficulty of obtaining accurate fundamental data. While various governments and private companies publish statistics concerning crop sizes and demand levels, these numbers are gross estimates at best. With the current global marketplace, even if you could obtain accurate current information, it would still be impossible to predict future supply and demand with enough accuracy to make commodity trading decisions.

Technical analysts argue that since the most knowledgeable commercial participants are actively trading in the markets, the current price trend is the most accurate assessment of future supply and demand. If someone is correct that for fundamental reasons, prices will likely move up strongly in the future, the commercial participants who have the greatest knowledge and influence on the markets should certainly be moving the price upward right now. If price instead is moving down, a lot of very knowledgeable people must think price in the future will likely be down, not up.

For this reason, almost all successful speculators learn to follow price action and not try futilely to predict turning points in advance. They seek to trade in tune with the large participants who move the markets.

In his classic book, Technical Analysis of the Futures Markets, famous analyst John Murphy summarizes
the rationale for technical analysis: "The technician believes that anything that can possibly affect the
market price of a commodity futures contract--fundamental, political, psychological or otherwise--is
actually reflected in the price of that commodity. It follows, therefore, that a study of price action is all that
is required. By studying price charts and supporting technical indicators, the technician lets the market
tell him which way it is most likely to go. The chartist knows there are reasons why markets go up and
down. He just doesn't believe that knowing what those reasons are is necessary."

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