Commodity Futures Trading: A Primer , by Al Martin

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by Al Martin

Commodity Futures Trading: A Primer

(9-4-06) It constantly amazes me -- the number of would-be commodity futures traders that come to InsiderIntelligence.com, eager to trade, yet who know absolutely nothing about commodity futures. More importantly, they don’t even know the very basic mechanics of the market. And that’s the purpose of this column. Before you can trade, you have to know the basics. In order to be a trader, what you need to learn before you ever start is the symbols for everything that you’re trading. You have to understand either the first or second letters of what is typically a 3-letter symbol to tell you what the commodity is. The final letter in the symbol is the contract month. So you need to learn the symbols and the months. Not only the individual items you’re trading, but you need to learn the symbol for each month.

For instance, we have had a subscriber, whom I have had to talk to repeatedly, who can’t even program his own trading screen from the firm he’s doing business with, because he doesn’t know what the symbols are. This is not as easy as you would think. In this new age of IB (Introducing brokers, also known as electronic brokers, or what I refer to as the electronic resellers of commodity futures services), these firms do not even provide their customers with old-fashioned symbol guides. I don’t know why they don’t. But for some reason, they do not provide clients with old-fashioned symbol guides the way the old retail houses used to. A list of symbols on paper, not something on a computer screen. It used to be on a piece of cardboard. It would be a guide that you stuck up on your board, your machine. You could leave it there forever, in the event you ever had a memory lapse or something. After a while you get to know what the symbols are by heart. It’s a little like riding a bicycle. But you’ve got to learn what the symbols are. You’ve got to learn the symbols for the month as well. And you also have to learn, in this new age, all other symbols related to that commodity futures contract because so many of the commodity futures contracts trade not only board contracts but electronic contracts as well. And the symbols for the electronic contracts are different than those for the board. That is also sometimes confusing for the beginners. The electronic symbols, for instance, will oftentimes have a W or an ES or a Z in front of them. And that becomes confusing to the inexperienced. Also electronic symbols can sometimes have a different second letter in the middle of the letter sequence, which is describing what the actual commodity futures contract is. Furthermore, most of the electronic symbols now, and even some of the board symbols that electronic reselling firms use, you have to put the last number of the year in as well, which makes 06. People see PNS06. What does the 6 mean? It stands for this year. For instance, let’s say you’re trading a September contract, the symbol for which is U. But you might be trading a U06, meaning 2006 contract. Or, if it is in the month of September, you might be trading a September ‘07 contract. Not only is it learning the system of letters and numbers which constitute the basic symbology of commodity futures trading, but it isn’t always easy to learn this anymore because none of the firms that I know of provide old-fashioned symbol guides.

The universe of symbols and contracts is probably a hundred. Then there are acronyms for what the individual exchanges. CBOT: Chicago Board of Trade; CME: Chicago Mercantile Exchange; NYMEX: New York Mercantile Exchange; NYBOT: New York Board of Trade Not only are there individual contracts for different months but there are also many derivatives thereunto. These are electronic derivatives. Then you have many contracts, some of which do not trade on the primary exchanges but trade on the KCBOT, the Kansas City Board of Trade, the Minneapolis Board of Trade, wherein most so-called “mini-contracts” are traded.

A mini-contract just means a smaller version of a contract. They’re all different. You’ve got to learn those as well. For instance, a mini-silver is one 5th the size of a regular silver. That’s just a for-instance. You have to learn the contract. And this gets into a second point. Learn the contract sizes, how many pounds, how many tons, how many bushels, etc. And learn the tick size, meaning what is every tick worth, the monetary value of each tick. For instance, in the Treasury bond futures contract, a tick is one 32nd of a point, meaning $31.25. A tick in the grains is 1-quarter cent, meaning $12.50. These are the things you need to learn. You should learn which contracts you’re trading have exchange-imposed limits; that is, the limit to which the price can rise or fall in one day. Not all commodities have limits. Some have limits in the front months; some only have limits in the back months. But you should learn the limits because, if you’re trading them, and you don’t know that the contract has limits, you could wind up getting short or long in the contract, having it go against you, and not being able to get out. The lumber contract, for instance, has a $10 daily limit. That is the daily permissible limit to which the value of the contract can rise or fall. So, if you are shorting the lumber on a rally and you’re not aware of this, as I find out many inexperienced traders are not, that the contract can rally limit-bid and lock there. Locked limit bid means the contract is bid limit with no offer. It means trading ceases, which means, if you’re short, you can’t get out. Conversely, you could be a seller on the way down. The same thing -- if it’s locked limit down.

What we’ve noticed, on InsiderIntelligence.com, is that people want to start trading and they get so anxious and so excited by trading. They get very enamored with the idea of becoming “a professional trader” and that’s where danger lies The preponderance of the inexperienced traders that come into this business still look at it as gambling. And that’s part of the problem, that they have the mind-set of gambling. But even if you want to equate it that way, even gambling has its own vernacular, has its own do’s and don’ts, its own rules. But I see this all the time on InsiderIntelligence.com. People will lose money needlessly by needless errors. Now, it’s one thing to make an error in judgment, but it’s another thing to make a needless mechanical error and lose money because you’ve forgotten what the symbol was of what you are trading. By the time you found out what the symbol was, typed it into the screen, the price has moved again a thousand dollars. Or you typed in the wrong symbol. Or you tried to type it in under the classification of the wrong exchange. These human or mechanical errors are a common problem. People, after seeing late-night cable TV infomercials about how to trade commodities in 3 easy steps, believe that, “Oh, well, we’ll learn the mechanics on the way. We don’t want to take up any time to learn mechanics.” And those who believe that will pay extra for their education. The other basic that you’ve got to remember all the time when you’re a trader is this -- you have to memorize what the margin requirement is in each contract you’re trading. You can’t be looking it up all the time. Otherwise, you wind up either going over the limit of whatever amount of money you have and creating a UDB, the bane of the brokerage industry, i.e. Unsecured Debit Balance. Some of the electronic firms have computer programs that will prevent you from doing so automatically. If you’re over the limit or you do not have sufficient margin remaining in your account, you’ll see the computer will not accept your order. However, only a minority of firms have that. People ask -- why wouldn’t they protect themselves? Because there’s only so much market for pure electronic trading. Most people still like the idea of calling a broker. And if you’re doing it the old-fashioned way, there isn’t really any way that a program like that is going to work. Because it won’t be able to stop you because the broker won’t be able to stop you. The broker wouldn’t be able to do it either. Nor is it the broker’s function to do so. He’s the order-taker, but you’ve got to learn what the margin requirements are on every contract you’re trading. You have to know not to get yourself in over your head, and to understand the dynamic leverage that’s involved in commodity futures trading. People don’t even understand that. They start with too small an amount of money. And therein lies another problem – under-capitalization. In every enterprise (commodity futures trading or buying a vending machine business for $3595 from a late-night cable scam show) everybody loves the idea of starting with a small amount of money and working up into a large amount of money. However there is a problem. That is a practicable impossibility in commodity futures trading. This is true with anything that involves multiple leverage. There is a down side to starting with too small an amount of money. Namely, professional traders, all the time, every day, have to have the ability to average out a trade. This is what we have to do to make money. You buy one contract of bonds. And then the bonds fall back 8 points. Then you buy another one, to average down. The market, then, rallies back and you get out with a profit. But if you did not have the margin ability to buy the other one down, then the market may not have rallied back to a point where you could make money or even break even. And, remember, when the market falls, if you’re long, every tick down eats into your margin. The reason why we increased our minimum recommended portfolio size from $25,000 to $35,000 over the past 12 months is because the commodity rallies that have occurred over the last 12 months have caused margin requirements by the various exchanges to be raised, oftentimes substantially. Therefore it costs more to trade a silver or gold contract, or whatever contract, now than it did 12 months ago. For instance, to trade the same variety of contract items 12 months ago that would have cost $25,000 then, would cost more than $35,000 now.

This is a function of the marketplace. The margin represents a percentage of the total value of the contract. If the commodity rises in price, then the overall value of the contract increases, which means the margin cost to trade it also has to rise. It’s the protection component for brokerage firms. The margin requirement was traditionally set at 10% of the contract value. Frankly that’s no longer true. There is no such fixed equation like there used to be when I started doing this in 1968. Now the brokerage firms are free to set margin independent of the exchanges, so long as they do not go below what is called the exchange member minimum margin requirement. But you will see nowadays that there is actually more leverage in commodity futures than there was in the past because the margin requirements in today’s more modern environment are oftentimes far less than 10% of the underlying value of the contract that you’re trading. It means: A) more leverage; B) more risk. In order to become competitive, (and I fault the industry for this) with the advent of these new electronic firms, which are mostly Internet-based, which I don’t particularly recommend doing business with unless you’re trading exclusively ‘qualified electronic contracts,’ the industry has dropped. You see margin requirements have declined relative to contract value in order to attract business. Now you allow people who don’t know anything to assume more risk. The brokerage firms, in order to attract business, are also assuming more risk because it means that people are going to run through their capital and be into an unsecured debit balance that the brokerage firm is either going to have to chase the client for or, more likely, ultimately write off. And here is the big point that should be made -- because I’m asked about this question all the time, of where to do business. I always recommend that you do business with an exchange member firm who actually has their own pit operations, within the individual pits, contract pits, or whatever it is they’re trading. When you add that caveat, you eliminate all of the electronic firms. Then you have to go back to the old-line retailers, which still exist, all of the small commodities retail houses, which are mostly Chicago-based, some of which have been in business for a hundred years. They’re all gone now. They’ve all been bought out. Lind-Waldoch bought them out mostly. However, that leaves only the big retail houses that have substantial commodity divisions: Merrill Lynch, AG Edwards, and Dean Witter.

You will see that the old-line retail houses that do have good service and timely fills, where you can get directly to the floor, which is a very key component as timeliness is absolutely supreme–the problem is that the old-line retail houses don’t want to do business with you if you are a member of the unwashed. When you talk to a broker at Merrill Lynch, he can figure out right away if you are a member of the unwashed or if you know what you’re doing. This is the new barrier in this business. And it really is a Catch-22. In recent years, particularly last year, the old retail houses took record losses from UDB’s, from having to write off bad accounts, in other words. Merrill Lynch more than 700 million in 1 quarter last year with commodity operations, because they took in so many unwashed that came in on a silver scam or a gold scam. By the scam I mean when the market was getting run and then it gets to Joe 6-Pack, who decides he ‘s going to be a trader. So he goes in with $10,000. A week later his account balance is minus $3,000. Very typical. And what happens is the brokerage firms are not really collection agencies. They’re not really equipped to track people down to try to get them to cover their UDB’s. In most cases, the old retail houses would simply write the losses off. Those losses got to be so large last year that the old retail houses now only want to do business with seasoned traders, for their own protection. The universe of seasoned traders in this business is very small. There are only 300,000 professional commodity traders in the United States -- making a living at it, who trade every single day, for, let’s say 10 – 20 years. So don’t believe the figures you hear on the late-night cable shows or in commodity futures magazines about there being 3 million commodity traders. That’s nonsense. The number of new traders coming into the market peaked in 2000, when the equity markets were high, for instance, when the equity markets peaked. But these became the so-called unwashed dot-com bubble burnout baby accounts.

So did they go from trading dot-com stocks to commodity futures? Yes. Most of them were S&P; traders. They traded the S&P; contracts (the “spoons”). You got a lot of people that suddenly thought they knew what they were doing because they were constantly trading long in a rising market. It doesn’t take a rocket scientist to figure that out. We have numerous, what is known in the trade as, dot-com bubble burnouts. One client, in particular, (And this is not an untypical story.) started with $5,000 in 1997 trading the spoons, the S&P; futures, worked that up to $250,000 by 2000 at the peak of the market, worked it back down to $5,000 by March of 2003. There are probably a million such citizens who did that. They never understood the markets. They never learned anything. They went along for the ride. But they didn’t know enough about markets to know when it had rolled over, when it had changed. The other historical trend is the gold rise and fall in the 1970s -- when so many people that had bought gold in `75 and `76 didn’t get out of it in `79 and `80. Once again, it was a lack of knowledge. These were people that, because they were making money, suddenly thought they knew what they were doing. One of the classic mistakes in this business is mistaking making money with knowing what you’re doing.

Here’s what everyone has to understand. I tell everyone this. Nobody believes me, of course, because I tell everyone the truth. The fractions of winners and losers that one sees in the commodity futures business frankly are frightening. On a long-term basis, it is also true that about 83% of all people will lose money.

What keeps people constantly coming in, a new crop of Joe Six-Packs every day, is that there is enough known about commodity futures trading within the general populace for people to get a general sense that there are fortunes to be made in it, which is certainly true. But this is a business of experience. You can be taught the mechanics, such as we have been discussing today. You can read a book about technical trading, how to trade from technicals, relative strength indexes, 14-day moving averages, moving average divided by histograms. That you can be taught. You can also be taught the fundamentals of a market: that is, to trade fundamentally based on the economic calendar, the news flows which affect the given commodity that you are trading. Ultimately, what a fundamental trader is to commodity futures is a supply/demand trader. In other words, in a bottom-line analysis of a fundamental, what do you think fundamentals mean? It means supply/demand equation. That’s what you’re trading, the supply/demand equation of an underlying commodity. Then, that is a whole different series of reports that you have to keep yourself apprised of. In other words, I tell people that if you want to trade the soybeans, the first thing is you’ve got to learn something about the soybean business. That’s true with any commodity. Learn something about the way the business works, the way the commodity is produced, the way it’s processed, the commercial aspect of it. Learn the whole distribution chain, what’s called “commercials” that are in the market, which are essentially the large dealers. Otherwise, the expressions that you hear every day in commodity futures trading, you’ll have no context to put them in. When you hear on Bloomberg or CNBC, “The commercials are in buying,” that’s not going to mean anything to the unwashed if they don’t understand what the word commercial means. It means commercial accounts. That’s why you have to know the jargon. It’s helpful to know something about the underlying business of the product that you’re trading. This is particularly true if you’re trading a fungible. What I find that people most resist is they want to look at this in terms of money. “How much money can I make? How much money did that trade make?”

And I tell everyone the same thing: “Take it from an old trader. You never look at the money. It’s the trade. You sold short on a contract that rallied to its technical resistance point. It was turned back.”

You have to be analyzing the underlying transaction and acting on it. Even if you equate this to gambling, there’s an old gamblers’ expression: “Never count the money.” The minute you count the money, it’s a one-way prescription to get blown out.

Why? Because you lose your focus. You start to get nervous. “Oh, geez, what if the contract goes against me another $2,000?” That can be of no concern to you. The minute you start looking at trading as money, it’s no good. You’ll never, never last in the business the minute you look at it as money. You are simply buying and selling based on support and resistance levels, based on fundamental news flows regarding the items or collateral news thereunto. It’s not as easy as it seems because everything is collateral in some respect to a certain group of other products. For instance, the bonds, dollars and gold contracts are all related, not just simply because they’re all financial instruments, but there’s a relationship between them because the fundamental news which causes, for instance, the bonds to rally will cause the dollar contract to decline in value because the relationship between the bonds and the dollars is inverse. The same thing can be said between the dollars and the gold contracts. As a matter of fact, when they don’t act according to classic economic dictum, it creates trading opportunities. For instance, if the bond contract and the dollar contract are rising at the same time, that cannot persist endlessly. It simply cannot. Economics don’t work that way. So you know eventually what will happen. They’ve got to part company, which means either the bonds or the dollars are getting overbought.

We’ve seen last week, for instance, that the NYBOT dollar contract, which we trade actively, was a consistent short-sell on rallies because it would rally with the bonds but then eventually would fall back. There are certain principles of economics that hold all the contracts together in a way, that cause both sympathetic and inverse relationships between various types of instruments. Watching the money instead of the trades, psychologically speaking, is when the human greed impulse overrides all other considerations, and that will screw up the deal. It will hobble your ability to trade the minute you start looking at what you are doing in terms of money. We’ve had many people that will come in and say, “Oh, well, I want to get long the silver, but I want to make $5,000. “ They have a preconception that’s wrong about the commodity futures. They come in with their own belief systems that cannot be moved by the market. That’s what they’ve been taught by watching the late-night cable scam shows. When somebody says to me, “Oh, I want to get long the silver because I want to make $5,000,” I say, “Look. I don’t want you as a subscriber. Go somewhere else. Because you’ll never be successful.” Between where the December silver contract is right now, there’s a whole series of support and resistance levels above and underneath. There are a series of buy and sell stops, what’s called stop books on the floor. I said there are various support and resistance levels. I said, you can’t look at it in terms of dollars.

So, in this primer version, the first thing to remember is -- have no illusions. I tell everyone this: Have no illusions. You can learn the basic mechanics, you can be taught fundamental and technical analysis, quantitative analysis even. But what you cannot be taught is how to feel a market.

To use the old-fashioned traders’ parlance: Is the tape heavy or is the tape light?

This is an intuitive sense that one learns over a period of time by sitting and watching the screens all day long, all night long, all afternoon long, whatever the sessions are, every day over a long period of time. We’ve had people on, who have held doctorate degrees in economics. They’re the first to get blown out because they have preconceived notions. Actually they know economics. One of the advantages they have is they do understand inter-market relationships. I’m leery of people with college educations in this is they try to apply macroeconomic principles to day trading. And you can’t do that. Because the macroeconomic principles have absolutely nothing to do with day trading. They’re not relevant to day trading or short-term trading. Whether you would be successful in becoming a professional trader or not depends on your intuitiveness, your ability to concentrate and to learn, over a long period of time, market momentum.

How do certain markets react to certain pieces of news, certain news fundamentals? How do they react to certain technicals? That is something that can only be learned through experience. Particularly younger people nowadays don’t understand, and I try to tell them. Of course, then they scoff at me until they lose all their money or until they find out I’m right. And then they give up. If you want to be a professional commodity futures trader, it is a life. It isn’t just learning reading books. It is a life. The level of concentration required, the time commitment required, you must have an overriding innate interest in the markets in order to commit so much of your life to it. The old-timers like me are people that have been sitting in front of a screen every day for 30 years or more. And even that, we’re just students. This is a lifetime. You’re always a student of the markets.

The minute you think you’re the master of the markets, you’re history. Remember, no matter how long you’ve done this, or how long you’re at it, you are always the student. The market is always the master.

Look at those old-timers who have been most successful and what they have in common. I’ve always thought that’s an interesting thing to look at because you will find commonalities between the old-timers. You will find that none of them are married. None of them have ever produced children.

For most people, you should be able to find a balance. But finding a balance, and I’ve learned in this business, believe me, finding a balance literally comes down to one’s intelligence quotient. Simply put, how intelligent are you? Because, if you’re going to lead a life outside of trading the markets, you have to have exceptional intelligence.

I am an absolute purist. In other words, all information that does not relate to the markets or economics in general is superfluous miscellany. And you don’t want that in your head. That’s why I only go out once a week for two hours. What you will find is, if you do this all your life, you can accumulate enormous wealth, simply enormous wealth. And in the commodity futures business, there are people who have accumulated enormous wealth. You don’t hear about them.

People will never spend the money. It wasn’t about the money to begin with. And therefore you’ve got to seek some sort of a balance. In seeking that balance, it means you have to put up with certain compromises. The main compromise being that you will never be as successful financially as you would be becoming a purist, if you have the intellect for it. Most people do not have the capacity in their brains to store so much information. People ask me, when they see the weekly results. Oh, well, I want to open a $35,000 account and make $15-20 grand every week. And they don’t realize that the ability to do that comes from 38 years of sitting in front of a screen every day. It comes from not having a life outside of the markets. If that’s what you want to do, 38 years from now, if you live in your 1-bedroom hovel, never go outside, eat and live, sleep the markets, you, too, will be able to do that.

We have several successful traders who are online that are like this, that are trading $30-50,000 accounts. They trade the most liquid items that have more predictable volatility. Like the bonds, for instance, which are much more based on the economic calendar releases than anything else. They trade, let’s say 8 bonds on 2 ticks. That’s a $500 gross ticket. And they’re gone for the day. And they’re off to the links by 10 AM; they’re done for the day. Then at night they come and they look, if you go out on the screens, they review all of the day’s action. Of course, these are people with Level One trade platforms. They’ll spend 3-5 hours at night just poring over what happened that day, what’s going to happen tomorrow.

In gambling its said you have to know when to hold ‘em and when to fold ‘em. In the commodity futures business, you’re actually given much more information to deal with than you do in gambling. And, of course, many more opportunities.

So many people that come to InsiderIntelligence.com, they’ve been down that road, so they didn’t have any understanding of what they’re doing. And they finally come to me and then they get a little sense of it, that, yes, you can make money. Yes, it isn’t what they were told, but by the time they get to me they’re so burned out. And here’s the pitch -- come to Insider Intelligence.com first -- before you get yourself burned out on the cable TV infomercial “How to Trade Commodities on 3 Easy Steps” scams.

* AL MARTIN is an independent economic-political analyst with 25 years of experience as a trader on NYMEX, CME, CBOT and CFTC. As a former contributor to the Presidential Council of Economic Advisors, Al Martin is considered to be a source of independent analysis for financially sophisticated and market savvy investors.

After working as a broker on Wall Street, Al Martin was involved in the so-called "Iran Contra" Affair as a fundraiser for the Bush Cabal from the covert side of government aka the US Shadow Government.

His memoir, "The Conspirators: Secrets of an Iran Contra Insider," (http://www.almartinraw.com) provides an unprecedented look at the frauds of the Bush Cabal during the Iran Contra era. His weekly column, "Behind the Scenes in the Beltway," is published weekly on Al Martin Raw.com, which also publishes a bimonthly newsletter called "Whistleblower Gazette."

Al Martin's new website "Insider Intelligence" (http://www.insiderintelligence.com) will provide a long term macro-view of world markets and how they are affected by backroom realpolitik.

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