Commodity trading: investment, options and futures

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You are proficient in stocks, the backbone of most financial markets. You are pretty well versed in mutual funds and have even started to dive into ETFs and REITs.

Now you are ready to start making your wallet a little more sophisticated. For the right investor, commodities could be the next step.

Is commodity trading risky?

Before going into the details of commodity trading, we will discuss the risks.

Commodities are a high risk, high return market that attracts investors due to their upside potential. A particularly successful trade can make a lot of money for the investor very quickly.

However, a bad transaction can cost you dearly. Many commodity contracts have virtually unlimited losses. Worse yet, unlike stocks, many can force you to owe more money than you have invested. Read on, but invest carefully.

What are commodities?

An investment in raw materials concerns specific raw materials such as wood, pork, soybeans, gold or petroleum. This is different from stocks and related titles, which deal with the performance of the company.

The typical commodity trader deals with futures and options contracts and is involved in buying or selling commodities for future delivery. A raw materials contract specifies:

• The specific commodity traded;

• The date on which the sale will take place, called the expiration date; and

• The unit price, called the strike price.

The profit margin on these contracts comes from entering into contracts today to buy or sell products in the future at a better price than they might at a future date.

The typical structure of commodity trading is the futures contract. This contract is literally an agreement to buy and receive physical goods or to acquire and sell such goods before the expiration date. If you do a futures contract for 100 pounds of orange juice, a truck will come in with cans of juice concentrate unless you sell or close the position.

Investors buy futures contracts for profit. A trader does not want to receive the actual goods, he wants to make money by entering into a contract of value.

Producers and retailers buy futures contracts to control prices and mitigate risk. Someone who actually uses a certain product is not trying to take advantage of the financial market, they are trying to plan for operating costs or profits.

Long positions vs short positions

Commodity contracts can involve the sale or purchase of materials.

A long position is a contract to buy the material in question at a future date for an agreed price. In this agreement, the other party agrees to acquire and then sell you the commodity in question.

A short position is a contract to sell the product in question at a future date for an agreed price. In this transaction, you agree to acquire and then sell the commodity in question to the other party.

Two examples:

Sam Investor takes a long position on 10 ounces of gold in six months at $ 1,000 an ounce. This contract means Sam agrees to buy 10 ounces of gold in exactly six months for $ 1,000 an ounce.

Sam wants the value of this contract. If gold sells for $ 1,100 an ounce on his contract expiration date, Sam will be entitled to buy 10 ounces of gold for $ 100 an ounce less than it is worth. This will make the contract worth $ 1,000 when Sam closes his position.

If the price drops, however, Sam will have to pay its value. If gold sells for $ 900 an ounce, Sam will now have to buy gold $ 100 an ounce more than he is worth. This contract will cost him $ 1,000.

Liz Farmer takes a short position on 100 bushels of soybeans in six months at $ 10 a bushel. This contract means Liz agrees to sell 100 bushels of soybeans in exactly six months for $ 10 a bushel.

As a farmer, Liz does this to establish price security. If the price of soybeans drops below $ 10 a bushel, she still guaranteed a 100 bushel market at the price she wants. If the price of soybeans exceeds $ 10 a bushel, she will lose the opportunity to make that extra profit because she will still be forced to sell for $ 10 a bushel.

Close a position

Cash settlement contracts

While technically a futures contract is a contract for the future delivery of a product, most are contracts between investors. These agreements are built around what is called “cash settlement”.

In a cash settlement contract, the parties never actually deliver assets. Rather, on the expiration date, they simply exchange the value of the contract for cash.

Fencing

In a physical delivery contract, on the expiration date, the parties actually show up with a truck full of raw materials.

Many commodity traders participate in the market for exactly this reason. Farmers, as in our example above, use the futures market to set the selling prices for their crops. Retailers will use it to establish predictable prices for products on the shelves. This is how the futures market was originally developed.

Investors, who do not wish to manage physical assets, will usually resolve a physical delivery contract by closing it. This is when the investor takes an equal but opposite position to his current contract. A long position will cancel out a short position and vice versa, creating a zero sum liability for the trader.

For example, in our gold trading hypothesis above, Sam Investor holds a long position for 10 ounces of gold in 60 days. If he took a short position in 10 ounces of gold in 60 days at the same price, he would hold an equal but opposite contract. The clearinghouse would consider its position as closed, or “flat”, as the two positions would cancel each other out.

Options vs. Futures

There are two main types of contracts in commodity trading: futures and options.

Futures contracts

In a futures contract, you, the contract holder, have an obligation to buy or sell the commodity on the given expiration date for the given price.

For example, a long position in crude oil for 1,000 barrels at $ 75 a barrel on June 1 means that on June 1 you have to buy 1,000 barrels for $ 75 a barrel.

Option contracts

In an options contract, you, the contract holder, have the right, but not the obligation, to buy or sell the product on the given expiration date for the given price. In addition, you can execute the contract any time before the expiration date.

For example, a long option on crude oil for 1,000 barrels at $ 75 a barrel on June 1 means that at any time before June 1, you can buy 1,000 barrels for $ 75 a barrel. If you do not exercise this right before June 1, the contract expires without being used.

Because options contracts don’t oblige you to anything, they don’t have the risk that a futures contract will. You can leave at any time without any additional loss.

Most options contracts come with a premium. These are the fees you have to pay when signing the contract. Futures contracts rarely carry premiums, but they generally require that you have a minimum amount of money in your brokerage account to cover potential losses.

Pros and Cons of Commodity Trading

There are two main advantages to commodity trading. The first is diversification. Often times, the commodity market will move countercyclically towards the stock market. Therefore, this position can help protect a portfolio against declines.

The second advantage is speculative gain. Simply put, when a commodity contract is doing well, it can perform dramatically. Investors can make a fortune with just one transaction.

However, and we cannot stress it enough, the reverse is also true. Investors can also lose fortunes on a single trade. This is because the main risk for futures trading is almost unlimited back-end risk. With a futures contract, you cannot predict how much money it may cost.

A futures contract is not like a purchase of stocks, where you can only lose the money you have invested. A futures contract actually requires future performance from you, the investor. This means that if your position ends out of the money (i.e. if it ends in a losing position), you will actually have to pay on that contract.

And a bad contract can end if you owe a lot of money.

This is why retail investors would be well advised to focus on options contracts. While options are more expensive initially than futures because of their premiums, they also come with a tightly capped risk profile: you can never lose more than the cost of the premium. This creates a mechanism for you to invest in commodities while maintaining a predictable risk profile.

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