How to Make Money in Commodities
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SECTION ONE
DEFINITIONS AND BASIC PRINCIPLES
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I
What are "commodities"? What goes on at a "commodity
futures exchange"? How can one beat the high cost of living
by buying and selling "futures contracts"? Answering
these basic questions is the purpose of this book. By the time
you are done, you should be well on your way to understanding
how to profit from inflations and recessions with a moderate
investment of risk capital (money you can easily afford to
lose). Commodity futures trading is a fastpaced game of speculation,
wherein traders try to guess whether the price of a commodity
will go up or down. The attraction of the game is that profits
come no matter which way prices go, as long as the trader has
gotten on the right side of the market before the big price
move travels very far. For a relatively small amount of deposit
money (called "margin"), the trader controls the
contractual rights to deliver or accept, at some set date in
the future, large quantities of goods (corn, silver, cocoa,
Treasury Bonds, etc.). The trader thus profits or loses as
the price of the commodity changes during the time the contract
is held. The relatively small margin as compared to the value
of the contract means that profits, and losses, can be many
times greater than the amount of money initially invested.
Best of all, the contract so held can be traded away (and profits
or losses realized) long before the delivery date, so that
no actual goods are ever physically involved.
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But now let's start at the beginning, with
the very word "commodities." The
dictionary defines "commodity" as "something
of use, advantage, or value . . . . an article of trade or
commerce, especially a product as distinguished from a service." These
abstractions hide the fact that commodities are an essential
part of everyone's daily life. When we go to the supermarket,
department store, bank or auto showroom, we go into the commodities
business.?The shock of prices that seem never to go down reflects
a keen awareness of commodity prices and their fluctuations.
In such painful moments, we know what commodities are: beef,
pork, chicken, eggs, potatoes, coffee, cereals, salad oil,
sugar, et. al. These are, as the dictionary said, things "of
use, advantage, or value." They are also all commodities
that can be traded on a futures exchange. A look about you
will speedily discover more commodities in your life. Is there
cotton in your shirt or dress? Was your house built with plywood
or lumber? Did you take out a mortgage to finance it? Does
your jewelry contain silver or gold? Have you borrowed money
from the bank lately, or invested in government securities?
In every case you were involved in a commodity transaction,
and in every case that commodity could be found on one of the
U.S. futures exchanges.
We live in a world of commodities. Our material lives are
nothing more or less than the organized process of producing
and distributing commodities. In the world of commodities,
there is a continual fluctuation between excess supply and
desperate scarcity. Those fluctuations translate into the roller
coaster ride of commodity prices. One year gasoline sells for
30 cents a gallon; the next year 60 cents; the next year $1.25,
and so on. A bumper crop of wheat drives the price per bushel
down to $1.50. Then huge orders from the Soviet Union send
prices to $6.00. Then the reverse occurs and prices plummet
a
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click to enlarge
The value of your dollar sinks
as prices rise. But traders in commodity futures can profit
whether prices go up or down! Futures can be a hedge against
both recessions and inflations.
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few years later when grain set for export is embargoed by
government directive. Coffee prices soared from $1.50 to $3.50
in seven months time in the wake of a crop freeze, then crashed
to $2.00 as the actual extent of damage became known. Sugar
rested at 10 cents for a year, then rose to 28 cents in five
months as global supplies dwindled. The list of examples, as
we shall see in Section Two, is almost endless.
All of us have had to deal with the effects of radical price
changes, keeping abreast of big price moves and adjusting our
purchases or sales accordingly. Whenever we do so, we act on
principles not unlike those of the commodity futures speculator.
If we go to the grocery and buy 30 pounds of sugar in the belief
prices are about to skyrocket, aren't we "speculating
in sugar"? If we put off buying coffee until prices drop,
we're betting on the price move of a commodity. The futures
exchanges offer traders an organized way of dealing with the
inevitable risks of price fluctuation. On the exchanges, the
trader acts much like the shopper looking for the best buy.
Instead of suffering the ravages of constantly changing prices,
the consumer or producer can go into the futures market and
exploit the price move for his or her own financial benefit.
How does this process work? How are ordinary people like you
and me able to buy and sell thousands of bushels of wheat or
thousands of pork bellies (uncured bacon) or millions of dollars
in government securities? We can do it because the industries
that use commodities want us to do it, and have set up the
futures exchanges to encourage us to speculate. The fact is
that, without the public speculator, the futures exchange would
cease to work. The futures exchange is the marketplace where
the futures contracts are bought and sold, where contracts
are written and where performance of the contract is guaranteed
by the brokerage firms and
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corporations of the "clearinghouse." The
economic functions of the futures markets are many and complex,
and are not the subject of this book. Simply stated, the organized
trade in the future purchase or sale of commodity goods provides
everyone in the affected industry with a valuable cost management
tool. The futures price, arrived at in the free market of the
trading floor's "pit" or "ring," represents
the best consensus on the future price of a given commodity.
Thus the futures price can be used as a touchstone by buyers
and sellers all over the nation. It allows producers and processors
to calculate, well in advance, their costs of doing business
and their anticipated profit (or loss). Since the futures contract
can, if so desired, be used for delivery, it serves as an alternative
to the local or cash market in the commodity.
Experience and studies have shown that the futures exchanges,
along with the many services they provide, would wither and
die without the public speculator. Why? Because those who are
in the industry that use the commodity, or that produce it,
want to use the futures market to control the risk of price
changes over time. They want someone else to assume that risk
until the crop is harvested or the lumber purchased. Enter
the speculator. The farmer who sells wheat to a speculator
on the futures exchange at a good price months before a bumper
crop is due transfers the risk of price fluctuation to the
speculator. The farmer expects that, as usual, a big crop will
drive prices down, which would lessen the value of the crop
as compared to what it could get at present prices. The futures
contract reduces the farmer's risk, for the profit on the futures
contract to sell at today's high price will increase as the
cash price goes down (cheap cash wheat could be delivered at
the high price called for in the contract). This futures profit
would largely offset the loss in
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value of the actual crop the farmer will harvest.
The farmer in such a situation is "hedging."
On the other hand, the speculator .accepts the risk in return
for the right to take a profit if the price of wheat unexpectedly
goes up. Maybe the speculator thinks the current crop forecast
to be overly optimistic, or expects new export demand to more
than compensate for the surplus supply. For a period, the speculator
holds a contract to buy wheat at today's price. If in the months
before harvest the price does go up, the contract for wheat
can be sold on the futures exchange for a tidy profit. Meanwhile
the farmer who was "hedging" will have taken a loss
on the futures position, but it will be one that is largely
offset by the increase in value of the anticipated crop. The
constantly changing numbers and needs of producers and processors
would make it impossible for them alone to establish a viable
trade in futures contracts. The crowd of speculators makes
it easy to buy and sell contracts. This "liquidity" of
the market and its usefulness to members of the commodity's
industry thus depends upon the participation of the speculator.
The speculator, in turn, is lured by low margin requirements
(usually 5 or 10 percent of the futures contract value) and
the chance to make incredible profits. Speculators also provide
the capital to run the markets, and thus to render the services
in information, price analysis and brokerage that are required
of an efficient trade in commodities.
What kinds of commodities can the speculator trade? Every
kind, from agricultural and plant products to precious metals
and financial instruments. The first futures exchanges in the
United States traded mainly in the grains pouring into the
market from the new farms of the mid?West. Chicago became the
headquarters of futures trading, dominated by wheat and corn,
while lively markets in cotton and sugar
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futures evolved around the export trade in
New York. In the mid?1960s, successful futures contracts in
live cattle, live hogs, and pork bellies transformed old ideas
about what kinds of commodities could be traded. A second revolution
occurred soon after when trading boomed in gold and silver
futures. A third explosive innovation, following the lead of
new futures contracts in foreign currencies, was the introduction
of the so?called "interest rate futures," including
Treasury Bills and Bonds, Government National Mortgage Association
certificates (Ginnie Maes), and prime rated corporation?issued
Commercial Paper. The proliferation of new contracts and the
expansion of the operations of the futures exchanges themselves
created unprecedented opportunities for the speculator. The
speculator's advantage is that, no matter how new the contract
is or how exotic the commodity, its price can only go one of
three ways: up, down, or sideways. Thus all contracts can be
traded with the same basic rules and methods.
The following is a list of the major exchanges and of the
principal commodities traded on each:
1. THE CHICAGO BOARD OF TRADE. 141 W. Jackson Blvd., Chicago,
IL 60604.
Iced broilers, commercial paper, corn, Ginnie Mae, gold, oats,
wheat, plywood, silver, soybeans, soybean oil, soybean meal,
Treasury Bonds.
2. THE CHICAGO MERCANTILE EXCHANGE. 444 W. Jackson Blvd.,
Chicago, IL 60606 (includes as a sub-division the INTERNATIONAL
MONETARY MARKET)
Cattle, hogs, pork bellies, lumber, potatoes, Treasury Bills,
gold, foreign currencies.
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3. COMMODITY EXCHANGE INC. (COMEX). Four World Trade Center,
New York, NY 10048.
Copper, gold, silver.
4. MIDAMERICA COMMODITY EXCHANGE. 175 W. Jackson Blvd., Chicago,
IL 60604. (Trades "mini?contracts").
Corn, gold, hogs,
oats, silver, soybeans, wheat.
5. KANSAS CITY BOARD OF TRADE. 4800 Main St., Kansas City,
MO 64112. (Grain exchange and wheat futures market. Stock exchange
contract proposed.)
Wheat.
6. MINNEAPOLIS GRAIN EXCHANGE. 400 South Fourth St., Minneapolis,
MN 55415. (Cash market and wheat futures.)
Wheat, sunflower
seeds.
7. NEW YORK COFFEE, SUGAR, AND COCOA EXCHANGE. Four World
Trade Center, New York, NY 10048.
Coffee, sugar, cocoa.
8. NEW YORK MERCANTILE EXCHANGE. Four World Trade Center,
New York, NY 10048.
Imported beef, platinum, potatoes, heating
oil.
9. THE NEW YORK COTTON EXCHANGE. Four World Trade Center,
New York, NY 10048.
Cotton, Frozen Orange Juice Concentrate.
10. THE NEW YORK FUTURES EXCHANGE. 20 Broad Street, New York,
NY.
Foreign currencies, financial instruments.
Each exchange publishes a variety of free materials that forms
a fine beginning for the speculator's trading library.
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The actual mechanics of buying and selling futures contracts
are relatively simple. If you wished to buy 100 shares of IBM
stock, you would call your stockbroker and say "Buy 100
shares of IBM at the market price." If you wished to buy
one futures contract in the pork bellies that will become your
breakfast bacon, you would call your commodity broker (who
may or may not also be a stockbroker) and say "Buy one
May Pork Bellies at the market price." The "May" in
your order signifies the contract month you wish to buy, as
each commodity trades in month?denominated units (normally
less than 12 per year). The order's details, and the price
stipulated, could be varied in dozens of ways, but the procedure
remains simple. Your broker will wire or phone your order to
the floor of the exchange where the commodity is traded. The
order will then be given to a "pit trader" who executes
the actual trade.
How can
this make you money? How can you profit from buying a futures
contract in pork bellies? If the value of IBM stock
rose after you bought, you would stand to profit. If the price
of pork bellies rose after you bought, the value of the contract
rises and you stand to profit. As the price of bacon in the
supermarket goes up, draining dollars from other shoppers,
you are making money on the deal. In other words, by buying
a futures contract for pork bellies, you can actually profit
from rising prices. In your own individual life you
have "hedged" your
losses in the cash world by offsetting them with futures profits:
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