Investing in Commodities – a Primer

Investing in Commodities

FACT:  Investing in commodities can create overnight wealth or wipe out a contract faster than you can shout, “Sell… Sell…”.

We are all affected by commodities, even if we have no interest in using them as an investment tool.  Food, precious metals, the cost of crude oil, all affect our daily lives as we purchase food for our families, gas for the drive to work, etc.  Conversely, commodities can be an excellent means to invest, but only if we’re well aware of how those markets work.

FACT:  While not a hard and fast rule, commodities traditionally move in opposition to stocks.

Times have changed and yes how investors look at commodities.  In past generations, investing in commodities was rarely looked at as a sensible investment, based on the time, expertise and money needed to buy contracts.  Those times have changed and today’s investor has multiple ways to sample the commodities market without adverse risk.

A Brief History of Commodities

The trading of commodities is as old as ancient Egypt, likely much earlier.  Eons before the stock market were even dreamed of, commodities were the currency of kingdoms,  and the principal reason the trading routes of old, in particular, The Spice Road, was created.  The harvesting of wheat, corn, and other crops was vital to the growth of entire regions, and savvy traders would venture their predictions on the coming harvest and how their lives would be affected.  This was perhaps the beginning of market speculation.

Where to Invest in Commodities

Over time, many of the world commodities exchanges have ceased to operate, or have merged to become larger single enterprises.  Some exchanges trade only a few types of commodities, an example being the London Meta’s Exchange, who deal exclusively in precious metals.

If you’re in the U.S., there are several primary exchanges that are run by the CME Group formed in 2006.  Exchanges under their umbrellas include the New York Mercantile Exchange,  the Intercontinental Exchange in Atlanta and the Kansas City Board of Trade.

FACT:  One of the nice things about using an exchange, instead of trading with an individual, is knowing the merchandise is authentic and in good shape.  The phrase, “never buy a pig in a poke,” comes to mind.  You’ll not need to worry about the quality of the commodity, it is certified by the exchange.

The Characteristics of Commodities

Looking at commodities trading from the point of supply and demand, it’s simple to understand.  As the demand for a particular commodity increases, and assuming the supply is limited, it follows that the price increases.  However, there are multiple factors, most beyond our ability to predict, that also influence the commodities market.  Case in point, as this is written, hurricanes have recently struck with ferocity in Texas and Florida, interrupting the flow of goods from that region, such as citrus from Florida and Crude oil from Texas, causing the price for these commodities to increase.  On the world stage, in l economies like China and India have put a strain on the production of steel and increase the demand for steel and crude oil.  For those positioned correctly in these markets, fortunes can be made or lost in a single day.

What Types of Commodities Can Be Traded?

Commodity trading isn’t simple, can be lucrative, is often volatile, and while it can be used as an investment tool, many use to satisfy their need for risk.  For the investor, the person needed to hedge their bets or diversify their holdings; there is a need to view the big picture, realizing that one commodity may (and probably does), influence the price of another.  The various categories are as follows.

Metals

When one thinks of metals, most immediately think of gold, which can be an excellent hedge against inflation.  However, there are other metals to consider, like, silver, platinum, copper, each crucial to a variety of industries.

Energy

Which includes crude oil, heating oil, natural gas and the petrol that powers our vehicles.

Livestock and Meat

No matter the economy, weather or political leanings of the world, we all must eat and the price of this commodity while somewhat stable, can also undergo wild fluctuations.  They include hogs pork bellies, cattle (both live and feeder).

Agriculture

Agriculture represents a vital part of our food chain, corn, soybeans, wheat, rice, cocoa, coffee, cotton, and sugar.

CONSIDERATION:   Strive to see the big picture, how some commodities are tied to another.  For instance, the price of crude oil affects the price of fuel.  This fuel is what powers the truck that delivers food to our local markets, driving up the cost of very food that sustains us.

VOLATILITY

The commodity market responds to the volatility of the world.  For instance, during times of inflation or stock market scares, investors flock to gold and other precious metals to protect their wealth and diversify their holdings.  It’s all interconnected.

Energy is the fuel that rules the world, the price of which can often rise and fall on a whim.  More often though, it is influenced by the global economic decision by OPEC, political strife and global investors who watch and weigh the energy needs of an always increasing and energy hungry world.  The advent of solar, wind and bio fuels are also part of the equation.

Grains or grasses, which are the base elements of multiple food items can be extremely volatile.  Often prices are dictated by seasonal changes, but population growth, as well as natural disasters in food producing centers,  should also be considered.

How Can You Trade in Commodities?

Futures

While future trading can be complex, at its essence, it is very simple.  A person agrees to buy a particular commodity, let’s say a bushel of corn, at an agreed upon price at some point in the future.  This allows the farmer to know, in advance, how much money their crop will yield and negotiate cash flow based on that.  When the time comes to fulfill the contract, the investor does so at the agreed up price, making money if the price has gone up, losing money if the price has gone down.  Of course, that’s an oversimplification but should illustrate the concept.

With the above thought in mind, there are two types of players in the marketplace, the user, and the speculator.

Users

Futures allow institutional users of commodities to know, in advance, how to budget for a particular item.  For instance, crude oil in the transportation industry, airlines, trucking, cruise lines would be among this sector, while the manufacturers of food products would need to budget for the cost of grains, soy beans or coffee.  By participating in the futures markets, they can hedge their expenses and avoid the possibility of volatility, which has the possibility of bankrupting a company if unprepared.

Speculators

It’s likely if you’re reading this that you’re a speculator or considering whether or not to become one.  You’d be betting on the price of the commodity to increase in value before your futures contract expires.  It’s doubtful you’d ever want to take possession of the physical commodity, oil, grain or coffee, instead of closing your contract before maturity and hopefully, reaping the financial gains.

How To Trade Future Contracts

Step one would be to open an account with brokerage firms that deal in commodities.  During the process, you’ll need to sign documentation stating you are aware of the risks involved.  At that point, you’ll need to fund your account and make a decision on which commodity you believe has the greatest chance for an increase.

NOTE:  Not Every firm trades in every commodity.

The amount you need to deposit will depend on the commodity of interest, and the minimum established by the brokerage firm.  When a position is establish, your account balance will be debited for the amount of the contract, which in most instances is 10% of the full value.  Because of this, a small sum of money can control a large stake in a particular commodity.  This can potential be extremely volatile, and because of the margins, your position can double or drop to zero in minutes.  This is high stakes poker played out on the world stage.  Come ready to play and be certain only to risk what you can afford to lose.

Advantages:

Relatively small amounts of money can control large contracts.  This means you can participate in a market you may not be able to easily afford otherwise.  You can choose to go long or short with the ease of a click or a phone call.  If the price moves in your favor, large sums of money can be made in minutes, hours or days, but the reverse is also true if you choose wrong.

DEFINITION:  Going long means you believe the price of the commodity will increase during the term of your contract while going short is the reverse, you believe the price will fall.

Disadvantages:

The very thing that makes futures trading alluring can also wipe out your funds in minutes, greed.  It’s important to always trade with your head and not your emotions.  Wild swings, often happening within minutes can send you scurrying to close your position before your contracts become worthless.  Futures trading is volatility on steroids.

Futures is certainly not for every investor; it takes skill and knowledge to understand the market, as well as the capital to trade without the worry of wiping out your nest egg.  If you have the heart of a gambler and the bank roll to match, trading futures can be fun, exciting and rewarding.  Be prepared for the thrill of the ride and be sure you have other, more stable investments to carry you through any c

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