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5 Rules Every Investor Must Know Before Trading Commodity Futures
You don’t need to be a homeowner to understand the real estate mantra, “location, location, location.”
It emphasizes the importance of resale value… It’s better to buy the cheapest house in a great area that will appeal to the largest number of potential future homebuyers than the nicest house in a less-desirable area.
Well, in commodity futures markets, the mantra is “liquidity, liquidity, liquidity.”
A liquid futures market means that there are many interested market participants who are buying and selling in that market at all price levels.
The greater the liquidity, the easier it is for an investor to buy and sell.
Illiquid futures markets, on the other hand, are a lot like roach motels… you can get into a position or trade, but you can’t get out!
Options contracts on some liquid futures contracts can also be illiquid. And, sometimes even the most liquid markets suffer from periods of illiquidity!
But just because a commodity is illiquid and difficult to trade is not a reason to ignore it.
Experience has taught me five rules that every investor should take into account before placing a single trade in any of the commodity futures markets…
Rule #1: Do not trust stop-loss levels in illiquid markets.
It is possible that you will not be able to stop-out of a losing position at the desired level because these markets are more likely to gap higher or lower than more liquidly traded markets. “Gap” means that the market-price can move dramatically with absolutely no trades occurring. When a gap occurs, stop loss orders cannot be triggered because there is no party on the other side of the trade.
I once tried to close out a long position in the cotton futures market. I put in a sell-stop order to protect myself from a devastating loss if I was wrong. Well, my sell order was not filled because the market gapped “limit down,” which means cotton reached the maximum amount it could move in one trading day.
Several days passed before the market was liquid again so that I could close out my position. The stop-loss order did not protect me at all, and I ended up risking more than I’d bargained for.
Rule #2: Prior to taking a long or short position in a new market, check the level of open interest and make sure that you understand the liquidity relative to more highly traded markets.
Lumber is a bellwether for the U.S. housing market and the overall economy. The global physical trading market in this commodity is considerable.
Lumber futures are another story. The futures market is illiquid… it tends to be very difficult to get into positions at good levels and even harder to get out of those positions!
In the lumber futures market, the “open interest,” which measures the number of open long and short positions, currently stands at 9,459 contracts with a gross value of approximately $262 million. By comparison, the very liquid corn market currently has an open interest of 1.2 million contracts worth $41.25 billion.
The corn futures market is over 150 times larger than the lumber futures market. Understanding the lumber market’s liquidity can save an investor from participating in a market that’s difficult to execute trades in.
Speaking of execution…
Rule #3: An investor must also look closely at how to execute.
In less liquid markets it is always better to buy when there is good selling in the market, and sell when there is good buying in the market.
It is much easier to execute trades in the financial and highly liquid commodity markets where market participants are buying and selling for many different reasons. A mistake that many traders make in illiquid commodity futures markets is that they try to buy the lows and sell the highs. The less liquid a market, the more difficult it is to trade and execute at the same time as the rest of the pack.
That’s why traders and speculators often go to an illiquid market such as lumber first when the economy is turning one way or the other because they know that they have to get into it (or out of it) before the masses.
Rule #4: Liquidity changes over time.
As markets become more “in play,” liquidity tends to increase. Look at the gold market – open interest today is over five times what it was in 2001. The market is more liquid than ever because it continues to be in play.
Futures markets can become more or less liquid depending upon the state of the markets that they represent. During certain periods even the most liquid futures markets can experience illiquidity due to factors like macro and microeconomic events, the price level of a commodity, or influential buyers and sellers. In these cases, the futures contracts become merely speculative vehicles.
I learned this rule the hard way. In the early ‘90s, I liked the copper market, so I decided to go long by purchasing COMEX copper call options. The commodity was trading around 80 cents per pound. I was so bullish that I was willing to pay a high premium of 12 cents for the option, which is why I bought the six-month 90-cent calls.
Copper exploded – the price rallied from 80 cents to 91 cents in short order. I called the copper options pit to take a profit on my call options, which I thought should be worth 18 cents at a minimum. The market-maker quoted me 11 cents to close my position. The market rallied over 13% and my option was down by 8%… Ugh! I got the commodity’s direction right but lost money anyway because of poor liquidity in the copper options market.
This takes us to Rule #5…
Rule #5: Make sure that the risk-reward is appropriate.
A purely speculative market tends to move with little or no liquidity and high volatility. These markets can offer traders and investors a much higher reward with much higher risk. In illiquid futures markets, an investor generally needs to look for much higher levels of profits to compensate for the much higher level of financial risk.
The Lesson: Do Not Ignore Liquidity
Commodity futures markets can be extremely volatile. But they can also offer tremendous opportunities for profits if you’re willing to take on the risks.
Although trading in less liquid futures markets can be risky, you should never just ignore these markets. Their moves often indicate how other commodity futures might move on similar fundamental and technical events.
Rice, for instance, is as important a commodity as corn, soybeans and wheat, which have much more liquid futures contracts. When there is a macro event that might affect the entire grain sector, rough rice futures tend to move first as traders go to this market first to take a position before the pack catches on (Rule #3).
If you want to buy and sell commodities successfully, understanding liquidity is just as important as knowing the fundamental and technical factors that underlie a market. It is also important to watch the illiquid commodities even if you do not trade or invest in them. These commodities often give clues or signals that can be extremely useful in your investment analysis!
Always remember the mantra in commodities investing … liquidity, liquidity, liquidity!
Happy trade hunting…
Andy Hecht
Editor, Trade Hunter
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