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A Primer on Commodity Trading
By Joshua Kunken
Although most investors are solely familiar with equity trading, such as stocks
or mutual funds, or investing in debt, such as bonds, commodity trading tends to
be ignored despite the fact that it possesses many advantages over other types
of investment instruments. Let's begin by defining what a 'commodity' is in the
first place. Commodities can come in many forms. Most commonly traded
commodities include lean hogs, live cattle, oats, wheat, metals, and even
currencies.
One of the attractions of trading commodities is the potential for gaining large
profits in a considerably short amount of time. Nevertheless, commodity trading
is considered by most as being extremely risky since most investors tend to lose
money. However, by performing your due diligence and determining whether the
commodity that you're interested in is either under- or overvalued, say if you
want to go long or short, respectively, you may be able to minimize the risk
involved in commodity trading. It may also help to have an experienced commodity
trader by your side to guide you.
When you're trading commodity futures, you're not truly purchasing nor owning
anything, unlike other types of investments, such as stocks or bonds. You're
simply speculating on where the price of a given commodity will be headed. If,
after doing your research, you believe that the price of coffee is going to
rise, you would purchase future contracts, or go long. On the other hand, if you
were under the impression that the price of sugar was going to drop, then you
would sell future contracts, or go short.
As was mentioned earlier, one can also purchase futures in currency or market
indices, in addition to buying or selling futures on commodities like cattle and
hogs. One advantage of trading futures on market indices is that you don't need
to invest a lot of money, as opposed to having to invest a considerable chunk of
capital if one were to purchase individual stocks. Let's illustrate with the
following, a $10,000 futures contract on the Nasdaq is equivalent to about
$200,000 dollars in stock. Let's assume you expect the market to rise shortly,
you could potentially buy many of the stocks that form part of the Nasdaq stock
index (the herd mentality) or you could purchase a Nasdaq futures contract.
Suppose you invested $200,000 in stocks in the Nasdaq, and if the index had
risen, you would have made a profit of say, $25,000. However, if you instead
purchased a $10,000 futures contract simultaneously, rather than investing
$200,000, you would have made the same $25,000, by investing with a lot less
capital in the first place.
A disadvantage to commodity trading is that it is usually done on margin in
order to leverage your investment, so a small drop in the price could
potentially cost you your whole investment. It is for this reason that one must
perform his/her due diligence and decide for him/herself if a given futures
contract will be a prudent investment. Although commodity trading can be fun,
albeit not without risk, it offers investors another way to diversify their
investment portfolios.
Joshua M. Kunken is Chief Currency Analyst for ForeignMarketWatch.com. His
articles have also been featured at ForexTrack. |
