Five Pitfalls of Trading Commodities

Trading commodities can be a treacherous business.

So if the boom in materials prices has you itching to jump in, there are some important pitfalls to avoid if you don't want to go bust.

For most would-be commodities traders, the first stop will be a look at futures and options contracts like those traded on the Chicago Board of Trade, the Chicago Mercantile Exchange(CME) or the Nymex(NMX).

Although the trading looks similar to that on the NYSE Euronext(NYX) it isn't.

Twice the Complexity

"One big difference between equities is that the time frame is finite for futures," says Jeff Christian, managing director at New York-based specialty commodities firm CPM Group.

"The futures contract actually expires -- and the same is true of an options contract."

That means not only do you have to get the direction right, but the timing also.

One very common mistake is that many people buy the contract way too close in, Christian says. For instance, someone buying an August gold contract in the belief the price of bullion will go up by the end of that month could be in trouble if the expected events don't transpire as quickly as desired.

The way to avoid that problem is to buy longer-dated contracts, even though they cost more, because that leaves a longer time range over which the event (such as a certain price point on oil) could actually take place.

"Always be willing to pay the extra premium for the additional time," says Christian.