There’s little question that commodities trading is a risky endeavor. From margin calls to extreme volatility, there are countless ways that traders can quickly lose money trading a variety of instruments. In this article, we’ll take a look at five commodities trading mistakes that traders commonly make and explore the best ways to avoid them [for more commodity news and analysis subscribe to our free newsletter].
Mistake #1: Failure to Use Money Management
Successful traders focus as much on mitigating risks as generating profits, using an array of money management techniques. For instance, an amateur trader may believe that a commodity position with a $1,000 potential gain and a $500 potential loss is always a desirable trade when, in reality, they should be more concerned with the odds of either possibility.
Some popular money management techniques include:
- Diversification: The most popular money management technique used in finance is diversification, which involves committing only a small portion of an account’s overall value to any single position. Any catastrophic event in one of these positions will then have a limited effect on the rest of the account.
- Position Sizing: Many commodities traders determine the size of each position based on the potential upside, potential downside, odds of upside and odds of downside using formulas like the Kelly Criterion. The results are mathematically optimized bets that generally have higher risk-adjusted returns over the long run [see also How To Lose Money Investing In Commodities].
- Automation: Commodities traders are often affected by emotion when trading, which makes automated trading strategies valuable. Setting stop-loss and take-profit points at all times can help automate each trade, while other commodity traders prefer to go a step further and utilize completely automated trading systems.
Mistake #2: Understanding the Implications of Margin
Many commodities require margin in order to capitalize on small absolute price volatility. But trading on margin is a double-edged sword, and can quickly backfire. For instance, a commodities trader may establish a position with a solid expected gain, but failure to account for volatility in the meantime can lead to a premature margin call and significant losses.
Some key points to understand about margin include:
- Initial Margin: The amount of money required in order to open a buy or sell position on a futures contract, where margin is typically 5% to 15%. For example, a $10 wheat contract worth $50,000 ($5,000 × 5,000 bushels) at a 5% margin requirement would lead to an initial margin of $2,500.
- Maintenance Margin: The amount of money that a losing futures position will require to bring margin back to the initial margin level. For instance, a $1,000 cotton contract with a maintenance margin of $500 that falls $250 will require an additional $250 in margin to bring the position back to the initial maintenance margin level [see also 25 Things Every Financial Advisor Should Know About Commodities].
- Margin Rate Calculations: Commodity margin rates are calculated using a Commodity Futures Trading Commission (CFTC) program called SPAN. The exchanges occasionally adjust their margin requirements based on market conditions, which makes it important for commodity traders to monitor their positions.
Mistake #3: Overtrading an Account
Overtrading is a common phenomenon that can result in excessive commissions that quickly eat into long-term profits. For instance, an account with 100 contracts per week will incur commissions of about $3,000 per week, while those trading just 100 contracts per month, earning perhaps the same overall return, will incur only about $700 per week in commissions.
Some tips to keep in mind when trading include:
- Use Wrap Accounts: Commodity traders that have managed accounts should consider reasonably priced “wrap accounts” that involve flat-rate commissions instead of commissions based on the number of trades placed each month.
- Adjust Strategies: Strategies that involve fewer trades should be preferred over those that involve high volume trading when overall returns in both models are similar. Traders should always carefully incorporate commissions into their models/systems.
- Don’t Over Commit: Commodities traders should be careful to properly manage the amount of capital risked on any single trade, even when they are very confident about the trade, in order to optimize risk-adjusted returns.
Mistake #4: Lacking Patience
Patience is a virtue-especially when trading commodities. Many beginning traders find themselves lacking patience, which can quickly result in higher churn rates, missed opportunities, and mounting losses. Practicing patience and limiting emotional responses to short-term price movements can help improve returns over time.
Some ways to improve patience when trading include:
- Use Trading Systems: Automated trading systems provide traders with a way to completely automate their decision-making. When trades start turning sour, they work on improving the system instead of using any guesswork.
- Trade After Hours: Many beginning traders place trades during market hours that they constantly change based on mood swings. Instead, they may want to consider placing trades only after hours in order to limit their emotional response.
- Plan the Trade, Trade the Plan: Automated trading systems may provide the least room for impatience, but setting take-profit and stop-loss points when trades are first placed can also provide a good measure of automation.
Mistake #5: Failure to Look at the Big Picture
Commodities traders should always look at the bigger picture, even before placing short-term trades, in order to maximize the odds of success. For instance, short-term technical analysis may point to a likely breakout, but long-term fundamentals, such as commercial trading patterns, working in the opposite direction could quickly derail the very same trade.
Traders can look at the big picture using many techniques:
- Commitments of Traders Reports: These reports are generated by the CFTC each week and provide an overview of commodity positions held by commercial traders (hedgers), institutional traders (speculators) and small non-reporting traders [see also What Are Options? The Ultimate Beginner’s Guide].
- Multiple Timeframes: Often, the trend is your friend when trading commodities, which makes it important to consider multiple timeframes when trading. For example, many traders look at 1-minute, 30-minute and daily charts before making a decision.
- Crop Production Reports: These reports can be found on the USDA’s NASS website each month and provide insight into supply and demand economics. Carryout or ending stock figures can tell traders if there’s a shortage or surplus in stocks that month.
Disclosure: No positions at time of writing.