By Victor Adair

On October 11, 2003, I listened to Mike Campbell interview Jim Rogers, the famous investor/traveler, on the Moneytalks Radio Show . Jim was making the point that he thought the bull market in commodities was going to continue when Mike asked him what he thought was the best way to play that trend. Jim replied, "The best way is to buy futures contracts."

He went on to say that futures markets aren't dangerous — that we hear horror stories about them because people use too much leverage — that it's better to use less leverage — that you can buy commodities just like you buy shares of major companies — you can pay cash or put up 50% of the value of the contract — you don't have to use a lot of leverage.

When Mike and I talked a few minutes later on the same radio show we continued on the topic of why the futures markets are the best way to trade commodities. We talked about the efficiency, the liquidity, the transparency, the low transaction costs and the "pure play" aspect of buying commodities instead of buying shares in companies that produce commodities. I also made the point, agreeing with Jim, that people often use too much leverage when they trade the futures markets — that the essence of my "22 Absolutely Essential Rules For Trading Success" was all about "playing good defense" while trading futures.

After the MoneyTalks Radio Show I decided to write down why I think that futures are the best way to trade commodities — and a variety of other markets as well. Here are my five reasons why futures contracts give you a powerful trading advantage.

Reason #1: Efficiency

The principle futures markets trade huge volumes and attract global participation. This liquidity allows traders to get into and out of the market in a very efficient manner — bid/offer spreads, for instance, are amazingly tight, allowing traders to buy and sell huge size without penalty. In the gold futures market, for example, the bid/offer spread for a 100 ounce contract of gold is typically only 10 to 20 CENTS an ounce while in the cash market (banks or coin dealers) the spread on 100 ounces of gold is often as much as 10 to 20 DOLLARS per ounce.

Transaction costs in the futures markets are also tiny compared to most other markets. Individual investors typically pay commissions of $50 or less to BOTH buy and sell a futures contract (which can easily have an underlying value of $50,000 or more).

People can open a futures trading account with a futures broker in much the same way that they can open a stock trading account with a stockbroker.

Reason #2: Transparency; True Price Discovery

Huge trading volumes and global public participation create genuine "price discovery" — meaning that the traded price - at that moment - is the sum total of the opinions of all participants — including some who have a very keen interest in the price. Arbitrageurs, acting in their own best interests, serve to police prices — if the futures markets are trading too "rich" relative to cash markets, for instance, they will instantly buy the cash markets and sell the futures markets and thereby bring prices back into line (and in so doing, they help "discover" cash market prices as well.)

The prices that are "discovered" on the world's commodity exchanges are instantly transmitted all over the world — helping all kinds of people to make more informed buying and selling decisions and helping to keep global market prices much more "honest" than they might otherwise be.

Back in the mid-seventies when I was getting started as a commodity broker one of the "old guys" told me, "If you want to buy copper, buy copper, don't buy Kennecott." He was referring to what was then one of the world's largest copper mining companies (which interestingly is no longer in operation) and he was telling me, in effect, to keep it simple.

The "pure play" aspect of futures markets will also help you focus on your motive for making a trade. If you're buying shares in a mining company that is exploring for gold because you think the price of gold is going higher and therefore their share price will rise too — think again — there are any number of reasons why their share price could fall even if the price of gold was to rise.

If you are bullish gold, and you want to profit from a rally in the gold price then buy gold - and the most efficient and cost effective way to buy gold is to buy a gold futures contract. If you want to speculate on the abilities and the fortunes of the management of a mining company — and there may very well be excellent reasons to do so - then buy their shares.

Reason #4: Leverage

Commodity exchanges require traders to deposit margin, or a performance bond, with the clearing-house when they trade futures contracts. In the case of gold an individual speculator would currently be required to post approximately $2000 for every contract he holds — when the underlying value of that 100 ounce contract of gold is worth approximately $37,000. The leverage in this example means that a $20 change in the price of gold would be equal to 100% of the margin requirement. If gold rallied about 10%, from $370 to $410, for instance, the owner of a contract would enjoy approximately a 200% return on his margin requirement. Now that's leverage!

Traders can gain even greater leverage on their initial capital because the exchanges allow them to use "unrealized gains" as margin for additional positions. Staying with gold as an example, a trader who used $10,000 to buy 5 contracts of gold (at $2000 margin per contract) would be able to use his "paper profits" to buy another 5 contracts if the gold price rallied $20 per ounce. Using "unrealized gains" to margin additional positions is referred to as "pyramiding" and while it's a wonderful thing when the market is moving in your favor it's a dreadful thing when the market is moving against you.

As Jim Rogers said during the Moneytalks interview with Mike people often use too much leverage when trading commodities and that can lead to big losses. The available leverage is tempting — especially when the markets are moving in your favor — and some of the traders who have made fortunes in the commodity markets have leveraged their positions to the max — but markets seem to have a habit of doing what you hope they won't do — and that can produce disastrous results if it happens when you are over leveraged.

The classic description of leverage is the "two-edged sword" — it cuts both ways. Learn to use it wisely and it gives you a powerful advantage to magnify your gains — abuse it and you will suffer the consequences.

Reason #5: Variety

Global futures markets provide a huge variety of trading opportunities — and not just in traditional commodities like grains and metals and foods. The financial futures markets include contracts on all kinds of interest rates, stock indices, and currencies — while the energy markets provide trading opportunities in a number of different products including crude oil, natural gas, heating oil, gasoline and electricity.

Most of the major exchanges also trade options on futures — which give traders an incredible range of strategies to pick from when they want to take a position in the market. Using options by themselves, or in combination with futures contracts, you can design very specific trading strategies to suit your individual risk tolerance.

The amazing variety of futures and options contracts allow you to take positions that represent "pure plays" on nearly any opinion that you can have about developments in our financial marketplace — opinions that can be expressed in an extremely efficient manner, in very transparent markets and with whatever level of leverage suits your specific individual requirements. As I've said many times, "If you've got an opinion about a market, I can help you structure the best possible trade using futures and options contracts."

If you are intrigued by the action in today's financial markets, whether it be currencies, interest rates, stock indices, metals, energy products or traditional commodities like grains and foods then take a closer look at exchange traded futures and options contracts. You can get started by looking at the web sites of the major exchanges like the Chicago Board of Trade, the Chicago Mercantile Exchange and the New York Mercantile Exchange.

In Conclusion

I've been trading financial markets for well over 25 years — and I've been a stockbroker and commodity broker since the seventies — and I am absolutely convinced, like Jim Rogers, that the best way to trade commodities is to use the futures markets. I also think that the futures and options markets are the best way to trade energy, currency, interest rate and stock index markets. I like the efficiency, the transparency, the leverage, the variety and especially the "pure play" aspect of the futures markets and I recommend them to you.

The material contained herein is for information purposes only and is not to be construed as an offer for the sale or purchase of securities, options and/or Futures or Futures Options contracts. While the information in this publication cannot be guaranteed, it was obtained from sources believed to be reliable. Any historical data provided above is for information purposes only and must not be construed as an indication or guarantee of any kind of what will be the future performance of the concerned markets or of the financial instruments described. The risk of loss in futures trading can be substantial. You should therefore carefully consider whether such trading is suitable for you in light of your financial condition. The high degree of leverage that is often obtainable in futures trading can work against you as well as for you. The use of leverage can lead to large losses as well as large gains.

Victor Adair has well over 25 years of trading experience. He has held a number of senior executive positions in the stock and commodity brokerage business.

Disclosure of Risk: The risk of loss in trading futures and options can be substantial; therefore, only genuine risk funds should be used. Futures and options are not suitable investments for all individuals, and individuals should carefully consider their financial condition in deciding whether to trade. Option traders should be aware that the exercise of a long option and/or the assignment of a short option would result in a futures position.