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Commodities: making the first trade

High crude oil prices have had one positive side effect—they have made commodity trading increasingly popular and one clear sign is the regular coverage in the media, writes Jayant Manglik.
None | By Jayant Manglik
UPDATED ON JUL 09, 2008 10:55 PM IST

High crude oil prices have had one positive side effect—they have made commodity trading increasingly popular and one clear sign is the regular coverage in the media.

The initial step to start commodity trading would of course be to choose from the national-level brokers with dedicated Research Desks and trained staff to support your information and trading needs. Once you have gone through the account opening process and you account is successfully opened, it is time to quickly figure out the best entry strategy. For first-timers in the futures markets, it is important to take note of the following:

Leveraging your position

Know that you are about to enter a leveraged position, which means that you would typically be paying only 5-15 per cent of the value of the commodity being traded since commodities are usually traded in the futures markets. For example, if you were to buy a kilo of gold at Rs 12,000 per ten grams, the total cost of the kilo would be Rs 12 lakh but you are required to pay only the Exchange-specified margin of, say, 5 per cent which works out to just Rs 60,000. What this means is that you can benefit from a favourable price movement to the full extent of your kilo of gold position by only putting up 5 per cent of the value as margin. Of course, the reverse would be equally true.

The ‘multiplication factor’

Typically, all commodities are quoted in units different from their lot size. Again, taking the example above, gold quotes at Rs per ten grams but the quantity you are buying is one kg (100 times of the quoted quantity). The minimum quantity you can buy is called the lot size. In other words, in gold, a one rupee movement on the screen really means a hundred rupee gain or loss for you.

Buy and Sell options

Be aware that you can sell and then buy back just as easily as you can buy first and then sell. Since you are paying a margin of 5 per cent on the gold, you can either take a buy position or a sell position as the first step of the trade. One of the major advantages of futures trading is that you can play the markets both ways and that potentially doubles the number of opportunities you get to trade because markets go up and they also go down.

Choose your commodity

This is not a business in which you can be jack of all and master of none. If you choose gold as your entry commodity, then you must be familiar with all the factors, which affect gold movement. Apart from information through the Internet, your broker is a potential source of updated information and reports. Besides, major business channels cover commodity futures trading in some detail several times during the day, with a focus on internationally traded commodities like gold and crude oil. If your regular business puts you in a position to understand a particular commodity, stick to that. For example, if you are a copper wire manufacturer you will have an insight into copper prices by virtue of being in the market. Futures derive their price from the underlying physical price and that gives you an advantage over others. Aim to leverage that advantage rather than try some new, exotic commodity to trade in.

Strategise your trading

If you have already done futures trading in equity markets, you will find it easy. As a first timer in futures trading, do not put all your money in one trade. Get familiar with the trading screen and see how the information flow affects prices. For example, when the warehouse stock positions are declared they will have an immediate effect on the prices of those commodities.

Discipline yourself

This is probably the single most important thing for a first-timer. Every act of financial indiscipline can have financially catastrophic results. Stop-losses are a must in leveraged markets; learn to use them without exception. Ask your broker for guidelines on safe trading and make sure you follow them. Do not be stubborn and adamant about what position you want to take in the markets, remember that markets have a mind of their own and may not sway according to your theories or predictions.

Entering the first leg of the trade is the easy part, learning to exit at the right time and the right price is the key to safe and profitable trading. Initially it may be better to keep targets but after a while you can try more sophisticated trading techniques. For example, when trades turn favourable, you can try to put trailing stop-losses so as to get maximum profits from a single trade – but this is after you have gained sufficient expertise in trading and are clear about the effect of news flow on the price movement of the commodity you are trading in.

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