This article is intended to be a mini-education that discusses the things you need to know about and do if you want to profit from commodity futures trading.
These seven steps will help you trade more successfully:
- Analyzing price chart patterns
- Using selection tools
- Using confirming tools
- Using timing tools
- Using money management
- Defining a trading plan
- Paper Trading
- Your commitment
1. Analyzing price chart patterns
You can tell a lot about a market by looking at its price chart. The price chart tells you basic things about the market, including its trend (going up, down, sideways) and its volatility (sedate price ranges or wide price swings).
In addition, there are different ‘views’ of any market. You can look at the ‘daily’ price, the ‘weekly’ price and the ‘monthly’ price. The daily price chart shows you about 10 months of price action. The weekly chart gives you an ‘aggregate’ of this market with a longer historic view of about five years. The monthly chart looks deeper into the past, covering about 20 years of price trend activity for the commodity. This gives you a way to determine what the historic high and low prices were (and when they occurred) for a commodity.
Analyzing price patterns can also tell you where price may be ‘expected’ to go - based on its historic behavior.
2. Using selection tools
By watching the markets every week, you can see price movement for various commodities. Some commodity prices will go up, some will go down, and others will stay in a trading range. To identify which markets are poised for a major price move - and in which direction the market will go - requires using graphic data that measures price pressures in the market.
There are several approaches to this measurement and they use different names but the purpose is the same. They are used to ‘select’ the markets that are ready for a major price move. Because of this, they are called “selection tools". Two such selection tools are called the Commercials and Market Sentiment.
The Commercials are the people who actually produce and consume the commodity. These are people who have banks of supercomputers run by high-paid analysts crunching numbers to determine what the commodity price will be in the future. An example of a Commercial entity would be Pillsbury, a company that makes cake mixes, etc. These people don't have the space to store all the wheat needed to make the flour used in their products. What they do is use the “forward" futures market to identify what price will be - when they actually need the wheat. This gives them a way to project what their fixed cost will be for wheat and lets them plan what they need to charge for their products to be profitable.
The Market Sentiment is the ‘public’ who have opinions about the market. Typically they are wrong - most of the time.
An effective selection strategy is to look for the Commercials being at an extreme (either high or low) in a market for the last twelve months. Juxtapose that with the Market Sentiment being diametrically opposed. When that happens, this market is ready to move in the direction specified by the Commercials.
But it doesn't tell you WHEN this market will move. To determine that, you need to use the Confirming Tools and Timing Tools.
3. Using confirming tools
Ok, so you're pumped up about the Wheat market because the Commercials are telling you this market is ready for a major price increase.
Now you need to figure out ‘when’ to get into the market. There are several Confirming Tools that are used to do this. One of them is the ‘14-day Relative Strength Index (RSI)". This tool measures strength and weakness in the market so you can use it to enter the market at a ‘good’ price. For example you may see that price is moving up and down. What you want to do is get into the market when the price is low. The 14-Day RSI helps you to identify when the price is low, allowing you to get into the market at a beneficial price.
Now that you're in the market, the next question is “How do I get out?" That's where the Timing Tools are used.
4. Using timing tools
The Timing Tools give you a way to identify where to exit the market and bank your profit. One timing tool involves the use of ‘%R’. It helps you to identify when the market is ready to ‘retrace’ from its original direction. This is when you close out your position and buy a new car with the profit you made.
5. Using money management
Money management is simply a way to control loss in a way that gives you ‘staying power’ as a commodity futures trader. For example, you have $10,000 in your trading account. Money management is just rule that has been pre-determined by you stating the maximum amount of money you will permit to be at risk in the futures market at any one point in time. Let's say that your limit is 10 percent. This means that at any one time, you can only have a total of $1,000 committed to all your trades.
Money management is a wise way of avoiding financial ruin. For example, if you committed your entire $10,000 to your trades - and they all became losers - you would not be able to trade until you put additional funds into your trading account.
The money management strategy helps you avoid total loss by limiting your exposure to risk. If you lost that $1,000 in the market, you would still have $9,000 available for additional trading. Now you take 10 percent which is $900 and use that as the maximum amount to use for all your trades.
6. Defining a trading plan
The Trading Plan is the twin to your money management plan. You also need a set of rules that you use to determine when to get into the market - and when to get out. Your trading plan is one of the items that you will be expending considerable time putting together. To work out the bugs to your trading plan, you need to ‘paper trade’ the plan until you can make money with it - over the long run.
7. Paper Trading
Paper trading is nothing more than simulating your trades. You take a position in the market and take notes of your successes and failures. This gives you a way to ‘fine tune’ your trading plan so that it makes money for you without risking your cash. Trading commodity futures is perhaps one of the very few activities where you can ‘simulate’ your trading without incurring financial risk before you actually do it. I recommend that you paper trade for at least 6 months before you venture into the markets. Remember, if you can't make money on paper, nothing magic will happen when you use real money. Actually, it will ‘magically’ disappear - and fast too.
8. Your commitment
If you're serious about learning to successfully trade commodity futures, it's going to take time, effort and study on your part. I'm not going to feed you a line of bull that “you can make millions overnight". Remember, if commodity trading was easy. . . everyone would be doing it. Just as it takes time and intense study to fly a multi-engine airplane, troubleshoot and repair automobiles, maintain an internet server, etc. , that same level of commitment is required from you - if you want to be successful at trading.
Special Note: There is substantial risk in trading commodity futures and options.
(C) 2008 Thomas Wnorowski
Thomas Wnorowski's flagship site Learn Futures contains contains 15 years of insight and techniques. His Commodity Futures Trading Course and Bullseye Commodity Trader Newsletter are tools you can use to educate yourself on Commodities and Options Trading.