Commodity Trading versus Stock Trading

R Hall, 13-May-2005

There are big differences between trading stocks and trading futures (commodities). While the stories of fortunes made or lost overnight on the futures markets are largely untrue, the futures trader, if using a sound trading system, can often make more money on the futures market and make it much faster. However, if the trading systemis not sound the trader can have greater losses.

This is because futures contracts are very highly leveraged. Margins (a deposit required) on futures contracts are typically much less than for stocks, and can be as low as 3% on some futures contracts compared with up to 50% for stocks. Alsol, futures investors are not charged interest on the difference between the margin and the full contract value.

The margins for futures act more as a performance bond or good faith deposit whereas the margin for stocks is more of a loan.

Although the margin on futures contracts is small, it shares in full the volatility of the underlying contract as that contract rises or falls, thus providing the leverage mentioned earlier.

Commissions charged by futures brokerages are normally much less than brokerage commissions for other investments.

Futures markets still tend to use the open outcry (auction type) method of trading which ensures very open, fair, and efficient markets. Also, it is much harder to trade on inside information as so many variables affect markets. Plus, futures markets are extremely liquid. Transactions can be completed quickly,lowering the risk of adverse market moves

If you own stocks you are an owner of the company that issued them. This allows you to share in the company’s profits, and losses, through share dividends, and increases or decreases in the stock’s value. It also gives you voting rights with the company. However, a company can go bankrupt, leaving you holding totally worthless stock.

When you buy and sell futures contracts you are only entering into a contract and don’t really own anything. What you have is an agreement to buy a commodity or financial instrument (wheat or treasury Bonds for example) at a set price at a specified date in the future.

The person on the other side of the transaction has agreed to sell you that commodity or financial instrument at that specified price by the set date. If you sell a futures contract prior to that date you have offset your position and have either a profit or loss on the trade.

The stock you bought three years ago is the same stock you can buy today. Futures, on the other hand, have very limited lives. They are traded in a regular series of contract months referred to as delivery months.

Futures contracts have expiration dates after which no further trading for that month can take place. The September corn contract you traded last year is not the September corn contract you are trading this year. In fact last September’s corn contract no longer exists.

Many futures contract months of the same commodity trade simultaneously on the market, sometimes even years into the future. The current contract is called the front month and the other contracts are called the back months. They are called back months even though they are for future months.

For example, corn trades for the months of January, March, May, July, September, November and December. Suppose today’s date is August 4, 2000. The current contract month for corn would be September 2000 and so is called the front month. The months of November and December 2000,
January 2001, March 2001, May 2001 and July 2001 are back months even though they are in the future and even flow into the next year. (This may sound confusing but it isn't!)

All of these months can be traded at the same time although most of the trading activity takes place in the front month.

When the current month expires the next contract month becomes the front month and so on.