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Who can forget 2008, when the price of crude oil climbed to $147 from $100 a barrel in less than six months? Who hasn't marvelled at the rising price of gold – up more than 35 per cent in the past 12 months alone?
The outsized profits delivered by these commodities over the past few years have attracted the attention of more than a few retail investors. Trading oil, gold, wheat, coffee and other consumable goods and materials, classified as commodities, can be lucrative. However, anyone venturing into this investing niche needs to consider the costs and risks involved before laying money on the line.
Buying and selling futures contracts, the medium used for trading commodities, is a risky business. It's a zero-sum game: For every dollar you make on a trade, someone else loses a dollar. And prices can be extremely volatile.
Given this, only certain personality types are suited to commodity trading: risk takers, the self-disciplined and those comfortable with market volatility. Investors without these traits should probably stay away and avoid undue psychological stress.
Becoming a commodities trader requires considerable preparation. New investors are best served by choosing a few commodities and understanding them well. This requires learning about:
- The commodity’s main uses.
- Major producing countries and the stability of their governments.
- Historical production and consumption figures.
- Who buys the commodity and what could affect their demand.
- The impact of the seasons, weather and natural catastrophes, such as earthquakes.
- The effect of strikes, economic news, technology innovation and man-made disasters, such as oil spills.
For astute traders, the learning never ends.
Mastering the nuts and bolts of trading is another upfront cost for new commodity investors.
The first step is to open a futures account with a broker licensed to trade commodities futures. Novice traders should look for a broker offering superior client support, extensive education and simulated trading accounts for testing trading strategies without risking cash. A broker-assisted account is a good place to start, because education and advice are available from experienced traders.
Other features to consider include the range of products offered, trading platform options, trading costs and the speed of execution, research on offer, account reporting and the firm's compliance history. The chosen broker must be a member of the Investment Industry Regulatory Organization of Canada.
Futures contracts specify the commodity, its quantity and quality, the delivery or price reference point and the delivery period and terms. A good grasp of typical contract terms and how each affects the value of a contract is essential. Broker tutorials and resources will teach you such fundamentals, as well as the mechanics of buying and selling a futures contract.
A futures trading course offered by a training school not affiliated with a broker could also provide a valuable perspective. Your goal is to acquire sufficient knowledge to develop a trading plan matched to your investing objectives, and to reduce the risk of making expensive errors.
While some account minimums can be just a few thousand dollars, realistically, investors need about $20,000 to get started trading commodities.
Traders holding positions must maintain a certain number of dollars, called margin, in their account. Margin is commodity-specific, changes with market conditions and represents only a fraction of the value of the underlying commodity. For example, with crude oil trading at about $85, one Canadian broker listed the initial margin to take a position in one crude oil contract (1,000 barrels) at $8,100, or about 9.5 per cent of the contract price.
The commission to trade a futures contract includes the broker's fee plus exchange, regulatory and other fees. Online trades can be as low as a few dollars per contract. Broker-assisted trades will cost significantly more, but are usually negotiable.
A number of risks are inherent in commodity trading.
Trades by Canadian investors are subject to currency risk because commodities are generally priced in U.S. dollars. If the Canadian dollar rises against the greenback, the value of a futures contract in Canadian dollars will fall, and vice versa.
Because of the leverage inherent in margin investing, small changes in the price of a commodity can cause large swings in the profitability of a futures contract. For example, if corn is $7 a bushel, and the margin is 5 per cent, a trader would need just $1,750 in his account to buy one corn contract (5,000 bushels) worth $35,000. If the price per bushel falls 10 cents, the contract loss would be $500. In terms of the money invested, that's a 29 per cent loss.
If the contract price falls sufficiently, it would trigger a margin call and the trader would need to immediately add cash to his account to maintain margin requirements.
It is possible to lose more that the initial investment in a futures contract because of the way futures are traded. Trading in a specific commodity halts for the day once the maximum daily price limit is reached, so a trader might not be able to close a contract until a large loss has occurred.
With the ease of online commodity trading, it's not difficult to overtrade. Similar to gambling, an unfortunate few will even become addicted to trading with potentially disastrous financial and emotional consequences.
Retail investors who trade commodities are matching wits with professional traders. To have any chance of success, they must have the right temperament, conduct thorough research, track market trends and news and follow a disciplined approach to trading. Those who are not prepared to make such commitments should not be in the game.
Gail Bebee is author of No Hype: The Straight Goods on Investing Your Money . She can be reached at gbebee@gailbebee.com.