Commodity investing is often shied away from by the majority of investors or traders. The average investor is often familiar with mutual funds, stock trading and even stock option trading but commodity investing (or futures investing) is often thought of as a different animal. But once you take the time to understand it you will find that it is not that much different than any other type of investing except for the concept of leverage.
Commodity trading and futures trading are often used interchangeably. When investing in commodities you are entering an agreement to buy or sell a physical commodity, currency or other financial instrument. Some common commodities that you may be familiar with are gold, silver, corn, sugar, coffee, pork bellies, live hogs, live cattle, oil, etc. You can invest in two specific ways. You can purchase a futures contract or you can buy an option on a futures contract. The two investment vehicles represent the same underlying but they are greatly different. In this article we will touch on commodity investing through futures contracts. We will have to deal with options on futures contracts in a later article.
A futures contract is just that: a contract. If you purchase a futures contract you have entered a legally binding contract to take delivery of the particular commodity on a specified date and a set price. This, of course, is what scares many investors off. Somehow they imagine that a truckload of wheat is going to show up at their front door someday. However, I have never heard of this happening. You simply need to sell your futures contract before it expires.
Let's look at some of the details of commodity investing. There are a few countries where the majority of commodity trading takes place. These countries are the United States, England and Japan. They trade on futures exchanges. Although electronic trading has changed the face of trading they are still similar to what was shown on the movie Trading Places when Eddie Murphy made a killing in the Orange Juice market.
The reason that commodity markets exist is so that the producers of these commodities (farmers, in particular) can get a handle on the pricing volatility in their respective market. The farmer is able to lock in a specific price for their product. This provides them with protection in the event that there might be a big price decline that could hurt them financially. This might be where it started and it is still used as such by farmers but the majority of traders in the futures markets are simply interested in trading and turning a profit.
The futures contract is an agreement between two parties. One assumes an obligation to take delivery of the commodity (the buyer) and the other assumes a responsibility to deliver the commodity (the seller). You can take either side of a futures contract. If you buy, you are assuming that the price of the contract is going to increase and if you sell short you are anticipating a decrease in the contract price.
Â Each futures contract will represent different physical product size. The amount of ounces represented in a gold futures contract will be different than that represented by silver futures. The same is true of all futures contracts. You will need to check what the contract size is for what you are hoping to trade.
Â Now a big aspect of commodity investing is leverage. A single futures contract represents a large amount of the physical commodity. For example, one wheat futures contract represents 5000 bushels of wheat. So if you purchased 5 contracts you would be leveraging 25000 bushels of wheat. That is a lot of wheat. Now I use the term leverage because you do not have to pay the entire cost of what 5000 bushels of wheat would cost when you buy it. You only have to put up a specific amount in a margin account to leverage to wheat purchase. The margin amounts are set by the exchanges and then some commodity brokerages will add an amount to that. However, it is typical to only have to put up about 5% - 15% of the overall cost of the product to enter a futures contract. Now this gives you great leverage. As an example it currently costs about $2500 dollar to leverage on wheat contract. Let's say wheat is trading at around $8.25 per bushel. This would require more than $40,000 to buy the contract outright but you only need to put up $2500. So for a little more than 5% of the overall cost you can leverage one contract of wheat. Now if the price of wheat when up $1.50 you would make $7500 in profit on your $2500 investment. You can see why traders love investing in commodities for this very reason. There is a lot of money to be made.
However, you can also lose a lot of money. In fact, you can lose even more money than what you invested. Remember you are leveraging a more than $40,000 contract. If it went to zero, you could lose $40,000. Of course that is not going to happen. But if it lost $2 then you could lose $10,000. If you begin to lose money and the money is not available in your account then you will have to send in money to meet your margin requirement.
Commodity investing can be an exciting venture but you need to know what you are doing so that you don't lose too much money.