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DEFINITION: Trading is the act of periodically committing resources to and
withdrawing resources from a market in an effort to attain incremental
profits.
The above definition of trading is the broadest I can conceive. In the
financial markets of today the resources most often committed are monetary,
although equities, bonds, commodities, currencies and derivatives can also
be utilized as trading resources. Use of non-monetary resources in
trading is most frequently undertaken by sophisticated traders in complex
transactions. An example of a trade that can be conducted safely by an
ordinary investor or amateur trader is an option trade known as covered
call writing. In this type of trade, an equity is used as the
underlying resource in order to execute the trade.
Trading came about as a method by which market prices could be stabilized
for both buyers (initially food processors such as bakers) and
sellers (initially farmers). A farmer raising wheat would enter
into a contract with a baker prior to the growing season to pre-sell his
crop at an agreed-upon price. If crop yields throughout the region
were high, the farmer could sell the contracted portion of his crop to the
baker at the agreed-upon price and sell the remainder in the open market at
a lower price (due to excess supply). If crop yields were poor, the farmer
might not be able to supply the entire contracted crop and would have to
deliver his crop at the contract price — below the open market price.
The baker would be assured of receiving at least some of his grain, and
would receive it at a price below the (unusually high) open market price.
You can see that this contractual arrangement has the effect of stabilizing
prices. Additionally, it assures the farmer a guaranteed market and the
baker a guaranteed supply of grain. Prior to the advent of modern
farming and financial innovations, a single bad year could bankrupt a
farmer; likewise, a bad crop could cause a bakery to shut down because
its owner could not locate enough grain or pay the high price at which it
must be purchased. As commodities contracts became an accepted method
of doing business, commodities markets were born in which contracts could
be traded on a supply and demand basis. Thus the farmer, who in a lean
year could be short on his contractual obligation and might find it
necessary to pay a penalty to the baker, upon recognizing that the growing
season might not be a good one, could buy an additional contract to cover
his shortfall before prices became too high.
Modern commodity markets are governed by the same principles as those
described above, but are much more sophisticated and have become global in
scope. Commodities trading has expanded to cover a wide variety of raw and
manufactured products ranging from perishables (wheat, orange juice,
coffee cotton, pork bellies) to metals (gold, silver, platinum, palladium),
energy (crude oil, heating oil, natural gas, gasoline) and currencies (U.S.
dollar, Euro, Yen). Finally, as commodities markets have grown, they have
attracted the attention of the novice trader, thousands of whom have
flocked to both stock and commodity markets with the prospect of making
their fortunes and retiring wealthy.
It is true that you can become very wealthy trading commodities, but the
risk involved is perilously high. Furthermore, a specific
temperament and a great deal of knowledge and experience are required to
successfully trade commodities markets. I would estimate that less
than one in one thousand individuals who undertake the task of trading
commodities will succeed; the remainder will lose a little or a lot of
money before they eventually give up or are washed out due to
inadequate finances. Many individuals trade commodities not so much for
financial reward but for the rush; these are not professionals
or even disciplined amateurs, but are undisciplined gamblers who are
addicted to the fast-paced action inherent in today’s financial
markets.
Disciplined market trading is not gambling; undisciplined trading is.
There is a great deal of skill involved in trading, whether it be in
the commodity markets, stock markets or bond markets. Ignoring this
fact guarantees failure. One cannot hope to become a successful
trader without
- Learning successful trading techniques, especially those involving
proper entry and exit points for a trade,
- Adopting a trading strategy which includes money management rules to
maximize preservation of capital,
- Performing an intensive period of simulations or paper trading
(“pretend” trading in which trades are recorded and
analyzed for effectiveness but no actual money is committed),
- Grounding himself or herself emotionally so that trading is looked upon
as a business rather than as entertainment or a way to get rich
quick.
Of the above requirements for successful trading, the emotional aspect of
trading is the most difficult to master. Paper trading serves several
useful purposes. Paper trading can
- Prepare you for what to expect with regard to what a volatile market
can “throw at you”,
- Test your abilities, the strengths and weaknesses of a trading system
you might wish to use, and the soundness of your money management
rules,
- Develop experience relating to trading practices and market
movements.
However, paper trading can never prepare you for the emotional rollercoaster
you may find yourself on once you actually commit your money to the trading
process. Emotions may compromise a trade either conspicuously or
subtly. You should never enter a trade when your decision is not
logically based and all outcomes have not been examined. If you feel
yourself becoming emotionally affected by a trade (Fear and
greed are the watchwords here.), you should exit the trade
immediately.
I have thus far has largely concentrated on the commodity markets. Trading
is a routine and constant activity in both stock (equity) and bond markets
as well as commodity markets. While trading vehicles and some trading
techniques vary from those used in commodity trading, the rules stated
above regarding successful trading apply equally across all markets.
Commodities markets tend to be the most volatile of all markets, with bond
markets being least volatile. All markets can be subjected to sudden,
destabilizing shocks that can quickly wipe out a trader who is highly
leveraged in the wrong direction. This is why proper money management
is essential to successful trading.
Finally, investors can utilize certain trading techniques to successfully
enhance their portfolio values. Market timing (strategically
determining market entry and exit points based on market levels and market
movements), incrementally entering and exiting investment positions, and
writing covered calls are but a few techniques available to investors who
are willing to educate themselves and follow the financial markets
carefully.
Authored by Kenneth L. Anderson.
Original article published 13 April 2004.
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Spider Stock & Commodity Trading showcases a variety of products and
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