Should you be tempted to speculate in commodity futures, think again. You are likely to have as much luck – and more fun – trying to break the bank at Monte Carlo – unless you really know what you are doing. You can lose your shirt playing chemin de fer; but in commodities trading you can risk losing the shirt you do not even have!
According to Stanley Zilch, director of Blue Skies Futures Research in Broken Springs, Colorado, 95 percent of those who speculate in commodities lose money. Even successful traders may make most of their profits from five percent of their trades.
There are two broad classes of people dealing in commodities: speculators and hedgers. Hedgers are producers and consumers of commodities, banks and institutions, who want to protect a given price or position in a commodity. Hedging represents 50 to 60 percent of the total market. It is the speculators who take the major risk and provide the liquidity for the hedgers to operate.
Most traders never receive or deliver commodities, instead speculating on the rising and falling values of contracts for future delivery. For every trade there is a buyer and a seller. A buyer is somebody who thinks the market will go up; a seller is somebody who thinks the market will go down. For every trade somebody gains and somebody loses. It is a zero sum game.
Speculators normally trade on margin. What this means is that they pay a deposit to their broker of 5 to 10 percent of the initial value of the contract. When the market moves, it multiplies their profit or loss 10 or 20 times.
Imagine that you are trading a contract of gold at $44,000 with a margin of only $2,500. If the price of gold moves $25, you have either doubled your money or lost it. In the latter case you will get a margin call from your broker to cover your lost deposit. Normally, you can limit your loss to the amount of your margin by putting in a ‘stop.’ A stop is an order to your broker to get you out when the market hits your price or bounces through your price.
Punters will tell you to take your losses out quickly and let your profits ride. Advice that is sometimes hard to follow.
Says Zilch: ‘If gold drops $100 overnight in Hong Kong as a result of some political news, and you are in New York with your contract of gold, the market in New York the next day is going to open $100 down. If your stop is in the middle, there is nothing you can do. You are stuck. A good broker can usually get you out. But you could be locked in a position and wiped out.
‘It’s the most anti-human character kind of game you can imagine. First, because in commodity trading the big money is made on the downside – selling short; which means selling something you don’t have in the hope that you can buy it back at a cheaper price. Second, the only way you will probably make money is to accept the fact that you are wrong. Most people say, I am right, the market is wrong!’
Speculators can be categorised according to six basic types of trading style:
-The Gambler: a seat-of-the-pants operator with more money than sense. He has no strategy. He picks up bits and pieces of information and buys and sells without knowing what he is doing. For example, he has a friend who has just bought 50 contracts of gold. He wants to be one up on his friend, so he buys 100 contracts. If gold happens to go up, he does not know at what point to get out. The gambler will lose money consistently. After a while he will either be broke and quit trading, or he will get smart and develop a system.
-The Wiseacre: a gambler with a system. He has started over to win back the money he has lost. But he is going to make the same mistakes as the gambler because he is so clever that he tries to beat his system. For example, his charts tell him the golden moment to buy gold. Unfortunately, gold goes down instead of up. So he gets a sell signal on his chart. But instead of getting out with a small loss, he carries his long position and ends up with a large loss.
-The Technician: the technical trader is a professional. He follows a system based on strict mechanistic rules, like ratios, moving averages, relative strength indices and butterfly spreads. For example, with precious metals, he will buy or sell depending on the price ratios between gold, silver, platinum and palladium. Let’s say the ‘normal’ ratio between gold and silver is 35 to one. If this moves to 40 to one, he would buy silver and sell gold forward and take his profit from both ends when the ratios move together again. He might also use moving averages to detect a trend that would signal a buy or sell decision. However, he is not infallible.
‘Over the past few years, technical trading has done badly because we’ve been having down-trending markets that have bigger and faster reactions,’ Zilch says. ‘The volume diminishes considerably, the guys on the floor starve; they know where the stops are, and they come and grab you.’
-The Cyclical Analyst: a highly specialised technician who follows the past performance of trading patterns in a commodity over a particular period, which may be two weeks or 20 years. His buy or sell decisions are based on the assumption that exactly the same price levels reoccur in regular cycles. This does not necessarily happen!
-The Fundamentalist: a person who studies basic economic factors, such as gold production in South Africa and long-range weather forecasts that will affect crops. According to Zilch, he is likely to be right eight times out of ten. But his knowledge, for example, of an impending disaster for the cocoa harvest in the Ivory Coast, may not affect the market at the time he is trading. So he can end up taking a huge loss.
-The Insider: someone who has a fantastic tip from a friend who is close to one of the Russian oligarchs that Russia plans to buy two million tons of grain and sell 400 tons of gold to pay for it. So he buys grain and sells gold. Unfortunately, the Russians do a special deal with the U.S. Department of Agriculture and take the grain from stockpiles rather than the market. As a result, grain does not move, gold does not collapse, and the Insider takes a beating.
Zilch believes that the temperament and experience of traders determines their particular management style.
‘In currency trading, for example, technical and fundamental styles can be very conflicting, and you don’t know who is right in the end,’ Zilch says.
Brokers are sometimes criticised as being more interested in the amount of commission they make on each trade than in giving sound trading advice to their customers. This is known as ‘churning an account.’ Good firms have compliance departments to control excessive trading. And in the United States, the Securities Exchange Commission is alert to this activity.
Another conflict that can arise, especially in London, is between the interests of hedger and speculator customers in the same firm. Zilch cites the case of a hedger who wanted to unload 3,000 contracts of cocoa. In order to avoid panic by throwing this amount of cocoa on the market, the firm sold it to another customer, a speculator, whose account he had carte blanche to trade. This ended in disaster for the speculator.
Another tale from London concerns a broker who doubled as a merchant, trading in physical commodities. A speculator had sold short 50 options on coffee. In the morning, he saw that coffee in New York was going through the roof. So he called the broker to buy 50 contracts when the market opened to hedge his options as he was short. Coffee opened in London at £3,000 a ton, the top of the market. It transpired that the broker had sold him physical coffee from his books because he had not stipulated that it should be traded from the floor!
The moral is, check out your broker. A good broker will also check out prospective customers.
‘Brokers should want to know everything about a customer, even if he puts up $1 million; he’ll want to know what is behind it,’ Zilch says. ‘The broker will then give a speculator a “trading limit,” which is a mutual precaution. The rule is, don’t speculate more than you can afford to lose in commodity futures. Try to assess the downside risk for every trade and if you are prepared to take it.’
Zilch stresses the importance of having a trading system. ‘If you have a system and it gives you a profit, this will be about three times the size of a loss,’ he says. ‘I think that in the long run – up to 10 years – any system is going to be profitable, provided you stick to it.’
But to paraphrase John Maynard Keynes: In the long run, we are all wiped out.
Roger Collis 1984 International Herald Tribune