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New Commodity Traders - Beware of the Leverage

Anyone who has traded or read about commodity trading should know that trading commodities and futures is very risky. That statement is very true. However, it doesn't have to be as risky as you might think.

The plain reason why commodities are risky is due to the huge amount of leverage of futures contracts. If you call up you broker and want to buy a futures contract of Gold, you would currently have to put up $2,700 in margin to control that contract. So, for a new trader who just opened a $5,000 account, he would have $2,700 set aside in the account to cover the risk on the Gold position and $2,300 would be left in available funds to buy or sell other positions - assuming no market movement, commissions, etc. Gold is currently trading at $650, so the total contract value is $65,000 (100oz. x $650 per ounce = $65,000). A commodity trader is controlling $65,000 worth of commodities for only $2,700! That translates into margin of about 4%. Some commodities require a higher percent for margin and others are lower.

Now we get into how this leverage has wiped-out more than a couple new commodity traders' accounts. It is actually pretty simple. The price of gold has been averaging a daily trading range of about $10 each day. It doesn't take a genius to see that a day or two of movement in the wrong direction can easily cause a $1,000 loss or more. That would be a 20% loss on the total account value ($1,000 of $5,000 initial account). This could have occurred because the trader's stop-loss was hit. The problem is that this type of daily range is likely to hit most stops that are close by and the market could continue in the direction you originally anticipated.

This, my friend, is the curse of the commodity trader with a small account. If you opened an account with $65,000 and only bought one contract of Gold, a $10 move in Gold against you would mean less than a 2% loss, which is very manageable. A 20% loss is not. If you have a few of these loses in a row, your account is almost wiped-out.

So, how does a new commodity trader with a $5,000 account overcome this problem?

You have to cut down on your risk exposure. Instead of trading a straight futures contract, maybe you could sell an out of the money option. Or you could buy a straight option or sell a covered option position along with the futures contract. This should lower your risk and volatility. This will normally allow you to stay in a trade longer and ride out the normal volatility. Try to hit singles and learn how the markets work. If you are constantly swinging for the fence, chances are your account will not last.

Strategies:

  • Buy Gold Futures at 650(random price used for illustration) - most aggressive
  • Buy Gold Futures and Sell a 670 call - less aggressive
  • Sell a Gold 640 put - less aggressive
  • Buy a Gold 650 call - less aggressive

I would also suggest that you trade less volatile commodities and futures. Stay away from commodities that average large moves each day. I would concentrate more on futures markets like: Eurodollars, cattle, oats, corn, wheat, soybean oil and sugar. These markets can get hot and become very volatile, so you have to use your judgment on whether to trade or not.

By Chuck Kowalski
CommodityBrokersOnline.com


About the Author:
Chuck Kowalski has been involved in the commodity and futures markets as a Commodity Analyst, Broker and Trader for more than 12 years. He holds degrees in Finance and Economics and is currently the editor of FuturesBuzz.com.