Many people have become very rich in the commodity markets. It is one of a few investment areas where an individual with limited capital can make extraordinary profits in a relatively short period of time. For example, Richard Dennis borrowed $1,600 and turned it into a $200 million fortune in about ten years.
Nevertheless, because most people lose money, commodity trading has a bad reputation as being too risky for the average individual. The truth is that commodity trading is only as risky as you want to make it.
Those who treat trading as a get-rich-quick scheme are likely to lose because they have to take big risks. If you act prudently, treat your trading like a business instead of a giant gambling casino and are willing to settle for a reasonable return, the risks are acceptable. The probability of success is excellent.
The process of trading commodities is also known as futures trading. Unlike other kinds of investments, such as stocks and bonds, when you trade futures, you do not actually buy anything or own anything. You are speculating on the future direction of the price in the commodity you are trading. This is like a bet on future price direction. The terms “buy” and “sell” merely indicate the direction you expect future prices will take.
If, for instance, you were speculating in corn, you would buy a futures contract if you thought the price would be going up in the future. You would sell a futures contract if you thought the price would go down. For every trade, there is always a buyer and a seller. Neither person has to own any corn to participate. He must only deposit sufficient capital with a brokerage firm to insure that he will be able to pay the losses if his trades lose money.
In addition to speculators, both the commodity’s commercial producers and commercial consumers also participate. The principal economic purpose of the futures markets is for these commercial participants to eliminate their risk from changing prices.
On one side of a transaction may be a producer like a farmer. He has a field full of corn growing on his farm. It won’t be ready for harvest for another three months. If he is worried about the price going down during that time, he can sell futures contracts equivalent to the size of his crop and deliver his corn to fulfill his obligation under the contract. Regardless of how the price of corn changes in the three months until his crop will be ready for delivery, he is guaranteed to be paid the current price.
On the other side of the transaction might be a producer such as a cereal manufacturer who needs to buy lots of corn. The manufacturer, such as Kellogg, may be concerned that in the next three months the price of corn will go up, and it will have to pay more than the current price. To protect against this, Kellogg can buy futures contracts at the current price. In three months Kellogg can fulfill its obligation under the contracts by taking delivery of the corn. This guarantees that regardless of how the price moves in the next three months, Kellogg will pay no more than the current price for its corn.
In addition to agricultural commodities, there are futures for financial instruments and intangibles such as currencies, bonds and stock market indexes. Each futures market has producers and consumers who need to hedge their risk from future price changes. The speculators, who do not actually deal in the physical commodities, are there to provide liquidity. This maintains an orderly market where price changes from one trade to the next are small.
Rather than taking delivery or making delivery, the speculator merely offsets his position at some time before the date set for future delivery. If price has moved in the right direction, he will profit. If not, he will lose.
In his book The Futures Game, Professor Richard Teweles explains the functions of the futures markets: “In addition to reducing the costs of production, marketing and processing, futures markets provide continuous, accurate, well-publicized price information and continuous liquid markets. Futures trading is [thus] beneficial to the public which ultimately consumes the goods traded in the futures markets. Without the speculator futures markets could not function.”
Since speculators perform the valuable functions of providing liquidity and assuming the risk of price fluctuation, they can earn substantial returns. The potentially large profits are available precisely because there is also a risk of substantial loss.
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