This column was originally published on RealMoney on Jan. 26 at 4:02 p.m. EST. It's being republished as a bonus for readers. For more information about subscribing to RealMoney, please click here.

In his State of the Union address Tuesday, President Bush again admonished his country for its addiction to crude oil, and at the same time touted ethanol as an alternative energy and a substitute for gasoline.

News that the president would mention ethanol sent corn futures prices sharply higher in Tuesday's trading. This is just one of the reasons that commodities are on investors' minds. Many people are able to pick up on the buzz about the sector, few are as familiar with how to profit from it. And while commodities investing is hot, neophytes can easily get their fingers burned.

Let's start the discussion with why commodities make such a compelling investment now. Once you're interested, I'll explain your options for commodities investing (futures, ETFs, related stocks) and how to get started (open a futures account, etc.). Last, I'll review some common mistakes that new commodities investors make.

The Buzz

Due in part to the president's speech, corn futures this month have rallied to a 10 1/2-year high, and presently are trading above $4 a bushel. Just last summer, the nation's major row crop was trading well under $3 a bushel. That's an eye-catching rise.

Corn is not the only raw commodity that has seen surprising price-gains the past couple of years. Wheat, crude oil, livestock and precious metals futures prices all have rallied strongly.

A voracious worldwide appetite for major raw commodities has been the driving force behind the surge in commodities futures prices. In recent months, raw commodity price indices such as the Reuters/Jefferies-CRB Index have risen to highs not seen for more than 30 years.

Speculator interest in raw commodities futures prices also has been a significant factor helping to drive these markets northward. A new report issued by the government's Commodity Futures Trading Commission just two weeks ago showed index funds and hedge funds (basically, large pools of speculator investment monies) have placed surprisingly heavy bets on the long side of many raw commodities futures markets. The annual returns of these funds have been very impressive the past couple of years, and new raw commodity-based funds and exchange-traded funds (ETFs) are still springing up.

The Nuts and Bolts

Commodity-futures trading involves an agreement by the investor to purchase or sell a commodity for delivery in the future:
  1. at a price that is determined at initiation of the contract;
  2. that obligates each party to the contract to fulfill the contract at the specified price; and
  3. which may be satisfied by delivery or offset, which means liquidating the futures trading position before delivery.

ETFs generally are set up to achieve the same rate of return as a particular market index. Similar to an index fund, an ETF will invest in either all of the market segments or a representative sample of the market segments included in the index. For example, Spyders ( SPY) invests in all of the stocks contained in the S&P 500.

Commodity-based ETFs can be volatile trading vehicles, but they also are easily accessible and don't have the high leverage that futures markets do. That means returns from ETFs may not match those that can be achieved through futures trading, but they also don't match futures' risks. Generally, ETFs carry less risk than trading in straight futures markets.

One caveat: Some newer ETFs can be thinly traded. As with any investment, make sure you understand exactly what an ETF is intended to capture and how it trades before you put your money down. New ETFs come out every day; in fact, Roger Nusbaum recently reviewed seven new commodities ETFs. With so many choices, you'll want to sift through them carefully.

One more step removed from commodities futures -- and carrying correspondingly less risk -- is the commodities investment that's probably the most prudent choice for most investors: investing in individual stocks of companies that are involved in raw commodities. Again, the downside is that returns may not be as high or as closely correlated to the aforementioned more volatile investment vehicles.

And as with ETFs, do your research; there are more factors than straight commodity prices involved with how a company can trade, though commodity prices certainly do affect how these stocks trade. Before you invest, make sure you understand how much a commodity's price move is likely to affect your chosen stock.

Those swashbucklers who do have discretionary investment money and enjoy the thrill of the potential for big profits (and who grasp the real potential for big losses) may want to open a futures trading account. The investor can call a futures brokerage and speak to an introducing broker, or go online to find a firm such as Merrill Lynch, Prudential Securities, Man Financial, Lind-Waldock and dozens of others.

There's the usual paperwork to sign, including risk disclosure documents, and the added step of depositing margin money (usually $5,000 or higher), before you're set to trade futures. But before you reach for your phone, first read on about some of the pitfalls.

Hot Investing, Burned Newbies

With all the talk and business media coverage of commodities, there has been keener interest among individual investors in trading commodity futures. However, before an unwitting investor calls his broker and instructs him to get him in on the long side of corn or soybean futures, it's prudent to first become familiar with the vagaries of trading futures markets.

The lure of trading futures is making huge profits with little money laid down. Where stock traders can operate on margin rates of 50%, commodity futures traders can own commodity contracts with less than 10% of the total value of the futures contract deposited with a broker.

For example: In corn, with around $1,000 in margin money deposited with a futures broker, an investor can own one contract on corn futures that is worth around $20,000. Every 1-cent price move in a bushel of corn amounts to a $50 change in the value of a corn futures contract, which equates to 5,000 bushels.

If the corn futures market at the Chicago Board of Trade rallies 10 cents a bushel during a trading session, then an investor on the long side of one corn futures contract would make a $500 profit. Sounds great so far, right?

Here's the catch. Commodities markets are volatile, much more so than stock markets. While the major U.S. stock indices very rarely make a daily permissible limit price move, commodities futures markets make daily limit price moves much more often. The futures exchanges establish daily permissible trading limits on price moves in futures markets to help control price volatility during very active markets. Just two weeks ago, corn futures opened and closed locked up the daily permissible price move of 20 cents a bushel. That's $1,000 a contract.

In the rough-and-tumble world of commodity futures trading, as with stocks, a correct call on price trend without the right timing will lose you money. This risk is compounded by the leverage involved. For instance, if you're bullish on the much buzzed-about corn market and want to participate in the current price rally using futures, you risk getting long in a mature bull market that's ripe for larger downside price corrections. Again, that's true of stocks, but because commodities move in such large increments, when the music stops, you could be left with nothing.

Remember that markets do not go straight up or down but tend to bob and weave. In futures markets, that bobbing and weaving can whipsaw a trader and quickly wipe out his deposit of margin money.

Still, the possibility of reaping large profits with the huge leverage offered in futures trading is understandably appealing to many investors. The key to achieving any success in the challenging arena of futures trading is to first understand the futures markets. Start by getting reliable information on futures trading and futures markets from the Commodity Futures Trading Commission and the National Futures Association, or my own Web site,

At time of publication, Wyckoff had no positions in any of the stocks mentioned, although positions may change at any time.

Jim Wyckoff is a senior market analyst for a free educational Web site. In addition, Wyckoff writes a blog offering current market commentaries every morning on Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Wyckoff appreciates your feedback; click here to send him an email.

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