So, you just opened your commodity trading account and now want to make the best of it. Unlike what you may have been led to believe, there is nothing to prove that commodity trading is far riskier than trading in equity or equity futures and options. In fact, what is needed in commodity trading is a proper understanding of the demand and supply dynamics of the commodity as well as an understanding how you need to protect your capital while trading. Any trading, by default, is fraught with risks. That is where it becomes essential to manage your risks in an intelligent way. Here are 5 absolutely ways to be successful in commodity trading…
Leverage is higher but you must use it judiciously
Remember that when you are trading in commodities there is a much higher element of leverage. What do we mean by leverage in this context? Of course, we are referring to the margin that needs to be paid in this case. For example, if you take a long or short position in index futures, you have to pay around 10% margin (that means a leverage of 10 times) and you have to pay around 15% margin for stock futures (that means a leverage of 6.66 times). When it comes to commodities the leverage offered is much higher. Normally, the leverage is as high as 14-16 times in many cases. In fact, you can further enhance your leverage if you are willing to put cover orders with an in-built stop loss. There are 2 things you need to remember when you use leverage in commodities trading. Firstly, you also need to define the maximum percentage of capital that you are willing to lose and trade accordingly. Secondly, in leverage positions, just as profits can be magnified, losses can also get magnified. Hence it is very important to use your leverage in commodities very judiciously.
Trend is your friend in commodity trading
When you are trading commodities, remember that you are trading the trend. Typically, commodities tend to follow larger cycles and sub-cycles. Of course, you will have bouts of volatility within these larger cycles. But you need to catch this trend and trade within the contours of this trend. A contrarian approach may work very well in case of equities but it may really help you in commodities trading. That is because, commodities are a lot more homogenous compared to equities and hence the key lies in catching the underlying trend and trade in the same direction.
Always keep a stop loss and never average losers
This is applicable in any kind of trading but the importance and significance of a stop loss gets substantially enhanced in case of commodities. There are 2 reasons for the same. Firstly, commodities are highly leveraged positions on low margins and hence strict stop losses are necessary to curtail your losses. Secondly, stop losses will ensure that you do not over expose yourself to any particular commodity. That will make your trading positions skewed in favour of few commodities substantially increasing your risk. A point that follows as a logical corollary from this point is to avoid the temptation of averaging your losers. For example, you may have bought gold at higher prices and at lower levels you may be tempted to average your position. It is better to exit your old position and take a fresh view after studying the trend.
Avoid overtrading and margin calls are a strict “No”
Most traders indulge in the trading activity largely for the adrenaline rush that it provides. That is not a very smart thing to do. When you get carried away in the heat of the moment, you are likely to make sub-optimal decisions and end up overtrading. Normally, when you are an aggressive trader, there is the temptation to over trade and try to recover your losses. Remember, that is not the way trading in commodities in practice. If you try to trade and recover your losses you will end up overtrading in the commodity market and incur more transaction costs without any commensurate improvement in the profitability of the positions. Ensure that you never get a margin call from the exchange and that means you need to manage your risks very smartly.
Trade to a plan and conserve your capital
Whether you are trading equities, futures, options or commodities, it is all about trading to a plan. When we refer to a trading plan we are talking about a set of rules that will act as a guide for your trading. You must set rules pertaining to the maximum exposure you will take to a particular commodity position. Your trading plan will cover how much you are willing to lose in a trade, in a day and in a week. Your trading plan must also very explicitly cover how you are going to conserve your capital and at what point will you shift largely into cash. The trading plan will lay out the circumstances under which you will increase or decrease your cash position. Trading in commodities is all about managing your risk and hence the primary focus here is to conserve your capital. The day you manage to do that and trade with discipline to a plan, your job is already half done.
Trading in commodities is fundamentally the same as trading in equities or other asset classes. Once you understand the nuances of commodities, you are in a better position to manage your expectations and protect your capital at the same time!