That '70s Show
, commodities are bringing the past back into vogue. We've seen oil gush to $55 a barrel and gold regain its luster by moving above $420 an ounce. And despite low interest rates and the reluctance of the
to admit inflation is nowhere on the horizon, the Commodity Research Bureau Index has risen some 51% over the last two years.
With the stock market as measured by the
having suffered through a wild five years and showing barely positive returns during that period, investors are looking at alternative asset classes to boost returns and round out their portfolios.
The fact that the major futures exchanges have enjoyed record trading volume and that the price of a seat on the New York Mercantile Exchange, where oil trades, at $2.2 million dollars, has eclipsed the cost of membership on the
New York Stock Exchange
are testaments to the growing interest and value of products.
The King of Commodity
This afternoon I had the pleasure of listening to Jim Rogers, the legendary investor, world traveler and author of the recent
. Rogers is steadfastly bullish on commodity prices, saying "the bull market in stocks and bonds is over and we are now just two years into what should be a 10-15 year bull market for commodity prices."
He cites the natural economic cycles and most importantly the influence that China is having on the supply/demand equation. "China will be the most important nation in the 21st century; they are now net importers of cotton, oil and steel, and the list will grow. The best way to invest in China is through commodities. It, unlike finished products, is the one area they cannot compete in and bring downward pricing pressure," he says.
But before we start fancying ourselves the next Jimmy Rodgers, we need to get acquainted with what's available, the vital statistics and the club rules concerning the buying and selling of the hottest commodity products. This may sound a bit "seedy," but remember, futures contracts, like their associated options, have a limited life span and are not necessarily about making a long-term commitment.
Speculation Is Not a Dirty Word
From the earliest days of the original Savannah Cotton Exchange and the milk and butter boys meeting under an old oak tree, the economic purpose of commodity exchanges has been to create a centralized location where traders could enact contracts based on daily price discovery. This still exists today, of course, as producers such as
try to lock in sales prices to end users such as
The ability to hedge is crucial to stabilizing profit margins and earnings. In the world of equities, the predictability of generating earnings plays a huge role in whether you should buy shares in a company's business. But for this reason, as
own Howard Simons has frequently opined,
trade the commodity, not the commodity stock to maximize leverage to the price movement in the commodity in question. You'll need a commodity futures account; some firms offering these include Lind-Waldock and CyberTrader. OptionsXpress is expected to offer futures accounts in the very near future -- no pun intended.
For the commodity trader, corporate earnings have little bearing on the decision-making process. Buying and selling are based on price prediction of the raw commodity, which is usually strictly a function of supply and demand. Certainly, there are factors -- weather, substitution costs, price elasticity, politics -- that exert external and economic forces. But issues such as management, mergers and legal rulings have minimal impact on a price.
So make no mistake: When trading a commodity, you're making a purely speculative decision on the direction of its price and nothing else. Unlike a business, which has a value based on earnings growth (which hopefully is built on an ever-upward slope), commodity prices tend to move in cycles, bound by some measurable historical levels.
Know the Product
When deciding to trade a commodity, you should have a basic understanding of the product. But I don't mean this in the Peter Lynch way of going to the mall and investing in what you know. Some people wouldn't know a soybean if they were crushed in a pile of them. For those interested in soybeans, the Chicago Board of Trade's
Web site is a good place to learn that each futures contract represents 5,000 bushels of beans, as well as other pertinent specifications and margin requirements associated with the commodity option contract.
Unlike stocks, which are priced uniformly in dollars per share and move in penny increments, the contract specifications for commodities vary widely. For example, one coffee future contract represents 37,500 pounds of coffee. It quotes in cents per pound and its minimum price movement is 1/20th of 1 cent, or $18.75 per contract. What's interesting is that the amount of coffee represented by the average daily volume on the New York Board of Trade, or NYBOT, is greater than the actual supply of coffee available in the world, so you know there is a fair amount of speculative activity joining the true hedgers.
There are also important differences between options on equity and commodities. While one stock option contract gains control of 100 shares of the underlying stock, commodity options are almost always constructed on a one-to-one basis; one option contract represents just one futures contract.
But some of what you lose in leverage is made up for in lower-margin requirements (most equities require a 50% margin deposit, while commodities futures can be purchased on just 20% of the underlying value), and the fact that one future contract controls a multitude of the underlying product.
Looking for a Sweet Move in Sugar
In the past I've penned separate pieces suggesting
using options to get long gold and coffee. The price of gold has moved up some 25% in the 18 months the strategy was recommended; coffee has gained an impressive 34% to $1.03 per pound. But it should be noted that while both positions were profitable, the full measure of these moves might not have been realized unless you were nimble enough to roll the positions forward. This highlights one of the obstacles of both futures and options: They have a limited life span and therefore are not conducive to long-term buy-and-hold strategies.
It is with these caveats in mind that I suggest establishing a long position in sugar. The NYBOT is the primary exchange on which sugar commodity futures are traded. Sugar actually accounts for over 40% of its trading volume. The NYBOT's
Web site provides contract specifications for both futures and options, along with their associated margin requirements.
The chart below shows sugar is ready to hit a new two-year high after forming a bullish bowl pattern yet still remains 80% below its alltime high, giving it plenty of room to run.
Put Some Sugar in Your Bowl
Fundamentals remain sound, even though South America, and specifically Brazil, account for over 65% of Sugar #11, which is traded under the symbol SB on the NYBOT. The recent tsunami will take some production out of the supply chain in the near future, creating some upward pricing pressure. Based on the time of consolidation, I think sugar could move from the current level of 9 cents to 13 cents per pound within the next six months. The suggested strategy would be to buy the July calls with a 10-cent strike.
Steven Smith writes regularly for TheStreet.com. In keeping with TSC's editorial policy, he doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He was a seatholding member of the Chicago Board of Trade (CBOT) and the Chicago Board Options Exchange (CBOE) from May 1989 to August 1995. During that six-year period, he traded multiple markets for his own personal account and acted as an executing broker for third-party accounts. He invites you to send your feedback to
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