Commodities Trading: Investing, Options and Futures

You've mastered stocks, the building block of most financial markets. You've got a pretty good handle on mutual funds and have even started dipping your toes into ETFs and REITs.

Now you're ready to start making your portfolio a little more sophisticated. For the right investor, commodities might be the next move.

Is Commodity Trading Risky?

Before getting into the details of commodities trading we will discuss the risks.

Commodities are a high-risk, high-reward market that draw investors because of their potential upside. A particularly successful trade can make the investor a lot of money very quickly.

However, a bad trade can cost you. Many commodities contracts have virtually unlimited losses. What's worse, unlike with stocks, many can result in you actually owing more money than you invested. Read on, but invest with care.

What Are Commodities?

A commodity investment deals with specific, raw goods like wood, pork, soybeans, gold or oil. This is different from stocks and related securities, which deal with corporate performance.

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

• The specific commodity being traded;

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

• The price per unit, called the strike price.

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

The typical structure of commodities trading is the futures contract. This contract is literally a deal to buy and receive the physical goods or to acquire and sell those goods by the expiration date. If you enter a futures contract for 100 pounds of orange juice, a truck will arrive with cans of fruit juice concentrate unless you sell or close out the position.

Investors buy futures contracts to profit off of them. A trader doesn't want to receive the actual goods, he or she wants to make money by entering into a valuable contract.

Producers and retailers buy futures contracts to control prices and mitigate risks. Someone who actually uses a given product isn't trying to leverage the financial market, they're trying to plan for operational costs or profits.

Long vs. Short Positions

Commodities contracts can involve either selling or buying the materials.

A long position is a contract to buy the materials in question at a future date for an agreed-upon price. In this deal, 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-upon price. In this deal, the you agree to acquire and then sell to the other party the commodity in question.

Two Examples:

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

Sam wants the value of this contract. If gold sells for $1,100 per ounce at his contract's expiration date, Sam will have the right to buy 10 ounces of gold for $100 per ounce less than they're worth. This will make the contract worth $1,000 when Sam closes out his position.

If the price goes down, however, Sam will have to pay its value. If gold sells for $900 per ounce, Sam will now have to buy gold for $100 per ounce more than it's worth. This contract will cost him $1,000.

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

As a farmer, Liz does this to establish price security. If the price of soybeans drops below $10 per bushel, she has still guaranteed a market for 100 bushels at the price she wants. If the price of soybeans goes above $10 per bushel, she will lose the opportunity for that additional profit because she will still be obligated to sell at $10 per bushel.

Closing Out a Position

Cash Settlement Contracts

While technically a futures contract is one for future delivery of a product, most are contracts between investors. These deals are built around what's called "cash settlement."

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

Closing Out

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

Many commodities traders participate in the market for exactly this reason. Farmers, such as in our example above, use the futures market to lock in prices for sale of their crops. Retailers will use it to establish predictable prices for goods on the shelf. This is how the futures market was originally developed.

Investors, who do not want to handle physical assets, will typically resolve a physical delivery contract by closing it out. This is when the investor takes an equal but opposite position to their 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 hypothetical above, Sam Investor holds a long position for 10 ounces of gold in 60 days. If he took a short position for 10 ounces of gold in 60 days at the same price, he would hold an equal but opposite contract. The clearinghouse would consider his position closed out, or "flat," because the two positions would cancel each other out.

Options vs. Futures

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

Futures Contracts

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

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

Options 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. Further, you may execute the contract at any time before the expiration date.

For example, a long option on crude oil for 1,000 barrels at $75 per barrel on June 1 means that at any time by or before June 1, you may buy 1,000 barrels for $75 per barrel. If you don't exercise this right by June 1 the contract expires unused.

Because options contracts don't obligate you to anything, they don't have the risk that a futures contract does. You can walk away at any time with no further loss.

Most options contracts come with a premium. This is the fee you have to pay upon signing the contract. Futures contracts rarely have premiums, but they typically require that you have a minimum amount of money in your brokerage account to cover potential losses.

Advantages and Disadvantages of Commodities Trading

There are two main advantages to commodities trading. The first is diversification. Often the commodities market will move countercyclically to the stock market. As a result, this position can help buffer a portfolio from downturns.

The second advantage is speculative gains. Simply put, when a commodities contract does well it can perform spectacularly. Investors can make fortunes off of a single trade.

However, and we cannot stress this enough, the opposite is also true. Investors can lose fortunes off of a single trade as well. This is because of the chief risk to futures trading is nearly unlimited, back-end risk. With a futures contract you cannot predict how much money it may cost.

A futures contract is not like a stock purchase, where you can only lose the money you've put in. A futures contract actually calls for future performance by you, the investor. This means that if your position ends out of the money (that is, if it ends in a money-losing position) you will actually have to pay on that contract.

And a contract that goes disastrously can end with you owing a lot of money.

This is why retail investors would be well advised to focus on options contracts. While options are more expensive up front than futures contracts due to 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 keeping a predictable risk profile.

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