I was almost shocked when someone recently asked me about commodities and I realized I’d never done an investment tip about them. It’s about time. First a simple explanation.
What the heck are commodities? Well they are things that you buy where one is pretty much the same as another. If you’re buying coffee (Starbucks aside) or wheat or orange juice or silver bars, one is the same as another. There are two qualifications for something to be traded as a traditional commodity. One is that it have the property of ‘sameness’. Two is that it can be stored for several months. That’s why frozen orange juice is a tradable commodity, but lettuce isn’t.
There are all sorts of commodities; currencies, metals, foods, natural resources, and in the last few years, stock indexes. That’s the weird one that will make your brain hurt. It’s a way to trade a basket of stocks as a commodity. But stock doesn’t actually change hands, it’s just cash moving around. Let’s put that aside for now and figure out a little about why we would want a commodities market at all.
Let’s say you are a miller of wheat and you’ve just gotten a call from Nabisco for several tons of wheat flour to be delivered in six months. They want to know the price. But how can you price it if you don’t know what wheat is going to cost? So you call up a farmer and you agree on a price for wheat that he hasn’t grown yet. The farmer now knows how much money he can make on his wheat, and you’ve locked in a price for the wheat you need. That agreement is a commodities contract.
Let’s say that one of the farmer’s neighbors hears about it and thinks that he can deliver the wheat a lot cheaper. So he takes over the obligation from the farmer to deliver the wheat. The farmer and the neighbor have just traded commodities. Eventually the wheat must be delivered, and the miller doesn’t care by who, just so he has it in 6 months. In the meantime, that contract could be traded 100 times by people guessing about what may happen to the price of wheat.
These days, those contracts are usually created by a commodity broker or investor, and many don’t actually settle in the commodity itself. Instead, the dollar amount due is paid. It’s that concept of settling the contract in dollars that has allowed commodities markets to move into things like stock indexes.
You might wonder, what’s all the fuss? How can anyone actually make any money in the narrow spreads in price you’d have in wheat over 6 months? Well the answer is leverage. In the stock market, minimum margin requirements are 50% in the US. But in the commodities market it’s only about 10%. So every move for you and against you is magnified 10 fold. You could make a fortune or lose a fortune overnight. And with margin your losses are not limited to your original investment. You could lose much more.
It sound exciting doesn’t it? And it is, just like a trip to the casino. But now I’m about to reveal to you a ‘secret’ about commodities (it’s actually well know, but not spoken about). Something that you’ll never read about in the books or newsletters or hear from a commodities broker. Pay careful attention. In the commodities markets, insider trading is LEGAL. You read that right. In the stock market, if a company knew about a takeover or a new product they couldn’t trade their stock on that information without revealing it to the public. But in the commodities market, if they know the Brazilian coffee bean crop will be bad, or that corn is going to be plentiful, the company and it’s employees can trade commodities contracts all they want and reveal nothing.
90% of individual investors make money in stocks, bonds and real estate over time. And 90% of individual investors lose money in commodities over time, because they aren’t insiders. Don’t believe the people who try to tell you different. They want you to give them money for something. A book, an expensive newsletter, or commodities commissions.
The lesson is clear. Leave commodities for the companies that need it to offset their risk in the price fluctuations in oil, or currencies, or pork bellies. Stick to the stuff that’s likely to make you money, however exciting commodities may sound.