Our society has never consumed so many raw materials. Large expansions in the developing economies of China and India have generated significant demand for commodities. This upward shift in consumption can create opportunities in the commodity market, but it can also lead to greater volatility in prices. Let’s discuss some risks in commodity trading that traders should consider prior to placing trades.
It’s the job of traders to try to buy a security and sell it at a higher price. Within the futures market, it may be just as common for traders to try to short sell a commodity at a high price and buy it back later at lower levels for a profit.
Whichever direction a commodity is traded, the goal is always to make money, but doing this consistently over time requires traders to be aware of the risks. That said, an essential part of a commodity trader’s job is understanding the risks and then trying to minimize exposure to them.
Some key reasons traders fail in the futures market are:
- The allure of easy money
- The lure of excitement
- Being unprepared to deal with losing positions
- As you can see, the reasons that draw traders to commodities have nothing to do with the risks they’ll take.
Perhaps the biggest risk commodity traders may take is not having a clear and coherent written plan on the approach they’ll use to try to be successful. An investing plan encompasses many of the core risks for investing in any security, but it’s even more important when you’re dealing with leveraged securities, like commodities. An investing plan should include these important components:
- What to buy
- When to buy
- How much to buy
- When to sell
These core components are necessary for a coherent approach for investing in the commodity market.
Knowing what to buy requires traders to understand the underlying product prior to investing in it. This includes being able to identify what forces influence the causal supply and demand for a commodity. It’s also important to have the correct information about the current status of a commodity’s supply and demand.
Knowing when and how much to buy is an essential element of money management. If you purchase too much of a security, especially a leveraged security like a commodity, you can easily risk too much in your account. Taking small losses, not large losses, is a key component to striving for long-term success in the market.
Knowing when to sell is also central to a sound money management strategy. Make sure your stop levels are tight enough that they’re likely to help avoid large losses, yet loose enough to help avoid getting stopped out prematurely. Experienced traders often place their stops at a level that requires a commodity to move significantly before getting stopped out. This requires proper position sizing at the entry. Remember, it’s important to have a specific exit strategy prior to buying a security. This way you can understand your risk prior to entering any position.
There are additional risks associated with commodity trading that can occur from time to time. For example, consider the stock market crashes of 2000 and 2008. Large banks and pension funds, which held billions in positions, significantly reduced their exposure to stocks and began buying relatively large commodity positions in the futures market. Although the positions for these institutions were small compared to the size of their portfolios, they had a significant effect on the prices of several commodities. These sudden buying events represented risk for individual traders, as large price swings moved counter to many of their positions.
Automated algorithmic trading, which continues to expand, is an additional risk that can create quick fluctuations in the prices of commodities.
Like all investing, trading commodities has its risks. Understanding these risks is essential to managing losses and making progress over time. Remember that creating a clear and coherent investing plan is important, but you also need to have the willingness and discipline to follow it.
Investools does not provide financial advice and is not in the business of transacting trades.
Trading securities can involve high risk and the loss of any funds invested. Investment information provided may not be appropriate for all investors, and is provided without respect to individual investor financial sophistication, financial situation, investing time horizon or risk tolerance.
Commodities markets have historically been extremely volatile, creating the potential for losses regardless of the length of time held. Commodity trading may be illiquid.
With a stop limit order, you risk missing the market altogether. In a fast-moving market, it might be impossible to execute an order at the stop-limit price or better, so you might not have the protection you sought. Trailing stop and stop market orders will not guarantee an execution at or near the activation price. Once activated, they compete with other incoming market orders.
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