Now, THIS was fun...What are Commodities with Listen Money Matters Podcast
Carley Garner, an experienced futures broker, was a guest on the Listen Money Matters podcast
What are Commodities?
Commodities are an asset class like stocks, bonds, or real estate. The reason many of us aren’t familiar with them is that unlike those other classes, commodities are not geared towards individual investors. The entities buying commodities are more often companies who need commodities to operate; airlines buying oil commodities to hedge against high prices is an example.
Commodities are not manufactured things like cars but things from the natural world like grains, minerals, or oranges.
There are soft and hard commodities. Soft commodities are things that are grown like cocoa, corn or cotton. Hard commodities are things that are mined from the earth like oil or copper.
Buying and Selling Commodities
Buying and selling commodities is speculative and the transactions are leveraged which is an easy way to get into trouble. If you think the price of corn is going to go up, you enter into a contract to buy it at the current price in the hope that the price will go up in the future and you will sell it for a profit.
Here’s an example of how commodities work. There is a drought predicted for the Mid West which means corn prices are going to go up. You own a corn chip factory. You buy corn futures now while the prices are low so you can still set your budget and know how much you are going to pay for the corn you need. You locked the price in.
You paid $3.50 a bushel. The price was $3.25 a bushel. You lost money. But for the chip factory owner, commodities aren’t necessarily an investment designed to make money. They are things that they need to operate and when they buy futures, they can keep their books balanced whether or not they were on the right side or the wrong side of speculating.
If you are just an individual investor in the corn/drought scenario, it is about making money. If you bought corn at $3.50 a bushel and it sold for $3.75, you made money.
But who keeps both parties honest? What if the chip company refuses to pay the agreed-upon price or the farmer holds the corn ransom until they get a better price? Commodities are traded on an exchange. Most commodities are traded on the Chicago Board of Trade or the New York Mercantile Exchange.
These exchanges are what guarantee the trades. If you want to get into commodities trading you can buy a seat on an exchange which costs hundreds of thousands of dollars or you can hire a broker as a middleman.
You can make trades on the broker’s platform which is not so different from buying and selling stocks with TD Ameritrade. You’ll pay about $7 per trade. Opening an account with a broker is like applying for a loan. Being a broker is risky because most of the purchases are heavily leveraged.
You can trade $50,000 worth of commodities as long as you have $3,000 in your account. If you lose $50,000 from an account with just $3,000, the exchange is still going to get their money but they come after the broker. And the broker is left to get their money back from you. Risky indeed. That’s why there is vetting involved and you have to meet the broker’s criteria to open an account.
Where Does it Go?
You want to trade commodities but you don’t have an corn chip factory. What are you going to do with 5,000 bushels of corn? If you get a delivery notice, you don’t have to clear out the garage. You can sell your delivery notice. Doing so is known as a retender. The buyer of the futures contract doesn’t want to take delivery of the commodity.
When you retender the delivery, the exchange puts it back into the system and it delivery goes to the buyer of the notice.
How are Commodities Different From Stocks?
Stocks and commodities are both traded but that’s where the similarities end. You own stock. When you buy a share of stock, you own part of a company. You don’t buy the actual commodity, the corn or oil. You enter into a contract for that commodity. You contract to be a buyer or a seller of that commodity.
Stocks don’t have a time limit. As long as you don’t sell the stock, you own it for as long as the company exists. This is why stocks are such a good buy and hold investment. Commodities have a time limit. Commodity contracts have a delivery month. As an individual investor, you have to be aware of that date and retender the order. If you buy and hold commodities, you’re going to have a garage full of corn.
What Drives Prices Up?
Some years ago gold prices rose dramatically. Why? A few things happened at the same time. E-trading was becoming more mainstream meaning anyone with a pulse and an internet connection was suddenly able to jump right into the market.
The dollar was tanking and the same kind of people who prepare for Armageddon by stockpiling guns and canned pasta buy gold too thinking it will make them the king of the new Mad Max-esque society they are sure is just around the corner.
So the prices were bid artificially inflated and just as the last dummy climbed aboard the bandwagon, the true value was revealed and they all lost money.
Speaking of gold, it’s always a popular buy when times are uncertain but should you buy it and is it really an important market indicator? The above story should indicate that gold should not make up much of your portfolio. The US hasn’t been on the gold standard for decades so it’s not as relevant as a market indicator as it once was.
Gold does well when things are uncertain but it’s very volatile. If you want to use it as an indicator at all, if gold prices are going up, people are panicking so it’s a good time to buy, buy buy stocks because people are selling them cheap to buy gold so you can get some good deals.
Commodities for Beginners
If you want to get into commodities, where should you start? Carley recommends grains because you can enter into mini contracts and buy just 1,000 bushels instead of 5,000. Gold is another good jumping off point because you can enter into mini contracts for just 10 ounces with only a $1,000 margin.
Lumber is her least recommended. It’s illiquid and there are not many market participants.
If you are interested in commodities, Carley literally wrote the book that can help you make sense of things. She is the author of Higher Probability Commodity Trading.