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Understanding Terms and Values Used When Trading Commodities

written by: Tim Plaehn•edited by: Jason C. Chavis•updated: 8/14/2011

Commodity trading can be exciting and profitable. However, for the beginner trader, the terms and units of measurement used in commodity trading can be quite confusing. This is why it's important for any investor to learn how commodity contracts are priced and valued.

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    What Makes Commodities Different?

    Commodities trading is a different world from the stock market. Different products, different brokers, different software and different terminology. That said, for the active trader, commodities provide one of the most liquid, low cost and high profit-potential trading venues. Some understanding of commodity terms and the units of measurement used in commodity trading is the first step to learning to trade in these markets.

    Investors use future contracts to facilitate the exchange of commodities. The regulating agency for commodity futures is the aptly named Commodity Futures Trading Commission, the CFTC. Commodity futures trade on various exchanges, depending on the type of commodity. Futures trading takes place in live trading pits at the exchanges as well as through electronic trading systems.

    Futures contracts are standardized for terms, size and units of measurement specific to the type of commodity being traded. A beginner commodity trader can become familiar with how one futures contract works and expand the types of commodities to trade from there.

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    How are Commodities Priced and Measured?

    copper5 

    In the most basic sense, a futures contract is for the forthcoming delivery of a standardized amount of a specific commodity.

    Some of the most common examples include:

    • A corn futures contract is for 5,000 bushels of number 2 yellow corn.
    • A lean hogs contract is for 40,000 lb. of hog carcasses.
    • Crude oil futures are for 1,000 barrels of oil.
    • A copper futures contract is for 25,000 lb. of the electricity-conducting metal.

    The value of a contract is the current futures price multiplied by the amount of the specific commodity in a contract. So if copper is trading at $4.41 per pound, one copper futures contract is worth $110,250.

    Fortunately, you do not need $110,000 to trade copper. Futures contracts are secured by a margin deposit set by the futures exchange. When you place a trade to buy or sell a futures contract, the margin deposit amount will be restricted in your commodity futures trading account as a deposit against that trade. The required margin deposit is based on the volatility and size of the specific futures contract. One copper futures contract currently requires a margin deposit of $5,738.

    Commodity traders are not as concerned about the value of a futures contract as they are about the change in value. The smallest value change for any contract is a "tick" and the tick value will be specific to the commodity. The smallest price change in copper is $0.0005 or 1/20th of a cent per pound. Corn trades in increments of 1/4 of one cent. The minimum price change times the contract size is the value of one tick. For the examples, a tick on a corn contract is $12.50 and the minimum change for copper is also worth $12.50. Generally, ticks in commodities are usually worth $10 to $15 each.

    The number of ticks in one cent provides the commodity contract value change per cent of value change of the commodity. A one cent change in the price of corn is four ticks or $50. A penny change in the copper quote is 20 ticks or $250. As you can see, with some commodities, a few cents change in the price of the economy results in a significant change in the value of a futures contract.

    A specific commodity future will have a range of future delivery dates which can be traded and the contract price will vary based on how far out the delivery is scheduled. The closest month contract will be the most active for trading volume and short term traders will trade this contract. When the cutoff date approaches to lock in a contract for delivery of the commodity, traders will roll their active trades out to the next contract month.

    The CME Group owns most of the futures exchanges in the U.S. and details on the vast majority of commodity futures contracts can be found on the CME Group website.

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    Be Sure to Practice Trading Futures Before You Go Live!

    One path that many take to learn and understand commodity contract trading is to sign up for a practice trading account with a commodity futures broker. Many brokers offer practice accounts where you can trade with simulated money. Practice accounts allow you to learn to use the trading software, understand how contract pricing and values work and develop your own trading strategy.

    A futures brokerage firm with practice accounts should help you select, download, install and set up trading software. The futures trading software systems can be quite complicated, especially compared to the systems provided by the mainstream online stock brokers. There is no reason to learn commodity trading by losing real money. Use the practice account and any educational information provided by the broker to become familiar with the features of the different commodity contracts. The CME Group website also provides educational material.

    When you are ready to start trading with real money, look at the e-mini contracts of your chosen commodity. The e-mini futures contracts are usually worth half the value of the standard contract with proportionally sized margin deposits and tick values.

    The futures market can be complicated for many investors, particularly when dealing with commodities. Along with a basic understanding of the contract process, it is important to leverage a strong knowledge in the units of measurement used in commodity trading. Once a person finds out exactly how the futures market works with things like corn, pork, oil and copper, it can be highly rewarding and profitable.

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