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
Chicago Mercantile Exchange
Although the trading looks similar to that on the
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
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.
Keep Tabs on Leverage
Another problem is forgetting about leverage with futures, says Terrence Martell, professor of finance at Baruch College.
Typically, only 15% of the value of the underlying contract needs to be paid up front before trading begins. In simple terms, that means a 1% move is multiplied 6.7 times. Although profits can be boosted, losses mount faster.
The way around that is to look for unleveraged plays, he says, to cut down on the risk. One example might be the
PowerShares DB Base Metals
, which tracks base metals futures prices.
Look for Liquidity
than financial markets.
That means sometimes it might not be possible to get in and out of a position easily or at a favorable price, although that's likely to be more of a problem for institutional players than retail ones.
Lack of liquidity was one of the problems with defunct hedge fund
, says CPM's Christian. They were measuring overall liquidity in the market and yet the contract months they held were illiquid, he says, and
Lack of Regulation
Although there is some government oversight in the futures markets by the
and other national agencies, in general, the commodities markets, especially the physical markets, are not regulated.
It means that activities such as "insider dealing" or "front running" probably wouldn't be illegal, says Jessica Cross, head of London-based specialty consulting firm Virtual Metals.
In the stock market, the use of material, non-public information cannot be legally used to trade. But it can be used in the commodities markets. That means materials producers can take advantage of changes in their own circumstances, such as pending labor disputes, to make money in futures markets.
For example, a copper miner who knows it has a production problem at one of its mines might decide to speculate in copper futures before the news is widely known. There would be nothing illegal in that, even though it puts the small investor at a disadvantage.
In addition, commodities brokers tend to be able to see the flow of customers orders before the trades are executed. That's illegal for stockbrokers.
The Greater Fool
It also needs to be remembered that commodities are not truly investments -- they throw off no cash dividends or interest coupons. The only way to make money by purchasing them is to sell them to someone willing to pay more, akin to the "greater fool" theory of investing.
While you hold these instruments, presumably waiting for the price to rise or fall in line with your goal, one way or another you'll be paying for the storage of the commodities, explains Matt Turner of Virtual Metals in London. That shows up in what's called the "yield roll" in the term structure of the futures market.
In short, if the price of the underlying commodity doesn't move, you'll likely be losing money -- albeit slowly. (Note: there are occasions when this works in reverse. But the area is fraught with complexity and would-be traders should consult with experts.)
There is tremendous asymmetry of information in the market with regard to demand and supply. Comprehensive data is notoriously difficult to find even for those willing to shell out big bucks.
Those not willing to pay for research may learn quickly that
commodities are different and are subject to separate supply/demand fundamentals, even when they may seem similar on the surface. For instance, corn prices have been rallying to record levels while wheat has fallen back.
If you think trading stocks is stressful, then trading futures is even worse. In some cases, the markets simply don't close. Gold, for instance, can be continuously traded from 4 p.m. Eastern time Sunday through 4 p.m. Friday.
Individual investors are pouring into commodities like never before. Feel free to join the crowd -- but make sure you know what you're doing before jumping in behind the rest.