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Stock & Commodity Trading

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 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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