ON THE MONEY: Investment basics: Commodity futures
In the next few weeks, we will review the various types of investments that an investor may consider, and in today’s column we will examine one of the riskiest types of investments-commodities.
These are types of assets for which there is demand, but which is supplied, generally, without any price differentiation among the institutions or persons who buy and sell these assets.
Commodities are priced and traded among buyers and sellers in an equivalent manner regardless of where the commodity was produced or by whom. Examples of commodities would include corn, soybeans, oil and copper.
The price of copper is virtually the same throughout the world, and fluctuates daily based on global supply and demand.
Automobiles, on the other hand, have many aspects of product differentiation, such as the manufacturer, the quality of the vehicle, and the “snob appeal” of owning that particular brand.
If buyers perceive that a Lexus, for example, is a great luxury car, that buyer perception will manifest itself in a higher price being charged for a Lexus. Not so with commodities.
In contrast, one of the characteristics of a commodity is that its price is determined as a function of the overall commodity market.
Well-established physical commodities are actively sold for immediate delivery in the “spot market,” or for future delivery in what is known as the futures market.
A commodity futures market (or exchange) is, in simple terms, nothing more or less than a public marketplace. The purchase and sale of a commodity, which must be made through a broker who is a member of an organized exchange, are made under the terms and conditions of a standardized futures contract.
A commodity futures contract is a legally binding agreement between two parties to buy or sell, in the future, on a designated trading exchange, a specific quantity of a commodity at a predetermined price. The date on which the commodity will be delivered and payment will be exchanged is known as the settlement date.
Buyers of commodity futures use these contracts to mitigate the risks associated with the price fluctuations of the product or raw material, while sellers try to lock in a price for their products. Like in all financial markets, others use such contracts to gamble on price movements.
A commodities trader can buy and sell commodities in a futures market regardless of whether or not one is in physical possession of the particular commodity involved.
When a person deals in futures one need not be overly concerned about having to receive delivery (for the buyer) or having to make delivery (for the seller) of the actual commodity, providing of course that one does not buy or sell a future during its delivery month.
A seller may, at any time, “cancel out” a previous sale by an equal offsetting purchase or a previous purchase by an equal offsetting sale. If done prior to the delivery month, the trades cancel out and thus there is no receipt or delivery of the commodity.
Trading in commodity futures contracts can be very risky for the inexperienced. One cause of this risk is the high amount of leverage generally involved in holding futures contracts.
For example, for an initial payment of $5,000, a commodities investor can execute a futures contract for 1,000 barrels of oil valued at $50,000 or more.
With this enormous amount of leverage, even a very small move in the price of a commodity could result in large gains or losses compared to the initial margin. Although actual delivery
of the commodity itself can occur in fulfillment of the underlying contract, the vast majority of futures contracts are either closed out of or offset prior to delivery.
According to the Commodity Futures Trading Commission, “trading commodity futures and options is not for everyone. It is a volatile, complex, and risky business.” Amen on that.
Commodity hedging is a technique utilized by the person who owns the actual commodity itself. For instance, if a manufacturer of copper wires expects the copper prices to rise in the next three months, he will buy a position in the futures market at current prices to offset the likely price increase.
Similarly, if the prices are likely to fall, he will sell in the futures market at current prices against the physical goods he holds. By hedging, the risk of loss is greatly minimized.
A word to the wise: if you are considering dabbling in commodity futures, to quote Tony Soprano, “fuggedaboudid.”
Greg Roberts is a certified financial planner with 35 years of financial and estate planning experience. Got a financial planning question for Greg? You may email him at firstname.lastname@example.org