How to Make Money in Commodities

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COMMODITY: Sugar
EXCHANGE: N.Y. Coffee, Cocoa, & Sugar
MARGIN REQUIRED: $2,000
PURCHASE PRICE (October): 12¢ per/lb
SALES PRICE (February): 22¢ per/lb
PROFIT PER/POUND:	10¢
POUNDS PER/CONTRACT	112,000
GROSS PROFIT:	$11,200
BROKERAGE FEE:	$75
NET PROFIT:	$11,125
CAPITAL INVESTED:	$2,000
RETURN ON CAPITAL:	555%
TIME PERIOD:	4 Months

      As this text proceeds, the reader will find, through inspection of actual market case histories, that the profits on this sugar trade are neither abnormal nor unique. Such opportunities happen literally every year, and in a number of different commodities. The possible returns on some may dwarf those of the above example. Consider for a moment the case of September Cocoa:

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The price of cocoa creeps along for 8 months between 30 and 35 cents, then zooms upwards to a high of 85 cents in only 4 months time. The cause was a scarcity of cocoa, registered in the above chart and eventually in the grocery store.

      A breakdown of a trade in September Cocoa futures most anyone could have made would have looked something like this:

COMMODITY: Cocoa
CONTRACT SIZE: 30,000 Ibs (old contract size)
MARGIN REQUIRED: $750
PURCHASE PRICE: 12¢ per/lb	30¢ per/lb
SALES PRICE: 22¢ per/lb	80¢ per/lb
PROFIT PER/POUND:	45¢
POUNDS PER/CONTRACT	30,000
GROSS PROFIT:	$13,500
BROKERAGE FEE:	$60
NET PROFIT:	$13,440
RETURN ON CAPITAL:	1,792%
TIME PERIOD:	5 Months

      Before going on to more examples, and to the mechanics of the trading method, a review of four basic principles underlying futures trading will be of help. The case histories of sugar and cocoa were based, we can see in retrospect, on one of these principles:

PRINCIPLE #1: In commodities, wherever the cash price of a commodity goes, the futures price of that same commodity will generally follow.

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The utility of the futures markets absolutely depends upon this close relationship of cash and futures prices. History shows, time and again, that futures contracts and futures markets that are not in a close correspondence with the commodity's cash markets will inevitably fail. Futures prices are not pure speculation subject to the mere whims and emotions of traders. They are framed and bound by the actual cash prices paid for goods in the real world. Futures prices may fluctuate in a range a bit above or below cash prices, but never very far. If they did, traders would buy futures and deliver against cash, or vice versa, effectively checking the imbalance. In practice, as the charts to the right show, the harmony is consistent.

      A careful inspection of the charts reveals a further significant fact supporting the principle. Notice that, from May through December, the prices shown on the May Pork Bellies futures chart are continually higher than those shown on the Cash Pork Bellies chart. The price patterns remain almost identical, but a price differential separates them. That differential grows smaller, and almost disappears, after January. In October the difference was about 10 cents; by mid-April it is only 5 cents. During those "distant" months, the futures price was "guessing" where cash would be many months later. As the May contract approaches the month of May, when the futures contracts can be delivered, the time differential has shrunk from months to weeks. Soon the futures contracts, unless liquidated by those holding them, will turn into vehicles for the delivery of cash products.

      Here is the reason why futures prices and cash prices generally follow each other so closely. The contracts for future delivery can be and sometimes are used for actual commodity transactions, thus binding their prices to the going prices on the regular cash markets. The futures

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exchanges spend thousands of hours and dollars in writing these standard contracts, consulting with potential industry users in order to come up with contracts that are both useful for speculative purposes and practical for cash business. Remember, the commodity trader does not literally buy and sell "commodities." Rather, the trader buys and sells pieces of paper known as "futures contracts."

      A futures contract is a legal document which calls for the delivery of an actual commodity at some prescribed time in the future. As the cash price of the commodity fluctuates, so will the value of that piece of paper. Prices can make large moves up and down many months before the delivery date, providing speculators with the chance to get in and out of the markets (hopefully for a profit) long before the contract falls due for delivery. If you hold the right to receive delivery of 5,000 bushels of corn, the value of your paper futures contract will generally move in the direction of cash prices. If the cash price goes up and the futures price follows, you profit. If the cash price goes down and futures follow, you lose. On the other hand, if you hold the right to deliver corn, the value of your paper futures contract will generally move in the opposite direction of cash prices. If the cash price goes down, you can "buy back" your promise to sell, and profit. If the price goes up, you will have to "buy back" at a higher price than you sold at, and you lose. Whether you are trading in silver or soybeans, the value of your piece of paper generally follows the price paid for that commodity at the cash marketplace, be it Switzerland or Chicago.

      Therefore, as a trader in commodity contracts, you will want to buy futures contracts if you expect a rise in the actual commodity's price, and sell futures contracts if you anticipate a decline in the price of the cash commodity. If the evidence suggests hog prices have begun an upward swing

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that should last for 10 or 20 cents, the speculator will consider seriously buying hog futures contracts. If a housing boom collapses and lumber prices start down, the trader will look hard at the possibility of selling lumber or plywood futures contracts.

      The second principle that concerns us, and that serves as the key to the method for making a fortune in commodities, also relates to cash commodity prices:

PRINCIPLE #2: When cash prices advance or decline out of a long narrow trading range, they usually continue to advance or decline for several weeks or months before returning to their original price level.

Think about this principle a moment, if you will. Imagine its application to the price of milk at the grocery store. Ample supplies have kept prices steady at 50 cents a quart for many months. One day you go to the dairy case and discover that milk has risen in price to 52 cents. What has caused this rise in price after so long a period of stability?

      The law of supply and demand has exercised it's power. The supply of milk available at 50 cents a quart has simply been exhausted. With the demand for milk not satisfied, the price had to rise. Whether demand pushed the price up, or a scarcity of actual milk, the old, longstanding price equation has been shattered. Once the price of milk has moved out of it's former range, it will continue upward in it's new direction as far and as fast as the market will allow. Whatever reason drove milk prices to abandon their old levels and seek higher ground will continue to exercise its influence until its strength is exhausted. If that reason, or combination of reasons, had the power to break through a price level that had held good for months, chances are it has the power to cause prices to move in the new direction for an appreciable period of time. Once prices have hit 52 cents, it would be reasonable

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to expect them to reach 53, 54, 55, and so on before (if ever) they fall back to 50 cents.

      Here we are not concerned with minor price fluctuations, or markets that have been swinging up and down continuously for weeks or months. A successful trading method selects the markets it will trade very carefully, isolating the ones that exhibit characteristics that promise the best chances for a profitable trade. The trader who knows the business doesn't worry about sitting out for days or even weeks. Patiently, the speculator keeps the charts and watches the prices, waiting for a price pattern to form that can easily, and with minimal risk, be exploited for hefty returns. In our case, we're watching for markets that have shown very little fluctuation in prices over considerable periods of time, usually weeks or months. We are preparing ourselves for the moment when prices shatter the old sideways pattern and move dramatically upward or downward. It doesn't matter why. What matters is that the old trend be long enough, and the new price move big enough, to qualify for trading by our method.

      Now let's do a case study. On the wheat chart you have a period of relatively stable prices followed by a sharp price advance out of the previously narrow trading range (called by some chart makers a "channel"). When prices moved through the $3.50 mark, what should experienced traders have expected? For six months the price of wheat had hovered between $3.25 and $3.45. Suddenly, at the beginning of May, prices continue to climb past the $3.45 ceiling of the previous trading range, hitting $3.75 by May 2. At $3.50, five cents above the highest point reached by the December contract in six months, was the price more likely to (a) go up or (b) go down? Common sense and Principle #2 answer (a), up.

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      In just two months time, the December contract hit $5.10 before suffering a corrective drop into the $4.20-$4.60 range. What drove wheat prices up? Most likely it was a radical change in the fundamental supply and demand statistics for the commodity. The wheat harvest in the United States usually begins in early summer. Clearly, throughout the winter, wheat from the old crop had been in ample supply, keeping prices steady. In late April, the old crop appeared to traders too small to adequately cover demand until the new crop could reach the market. The squeeze was on. Prices on the cash and futures markets both soared as the scarcity of wheat drove prices sky?high. Once new crop wheat began to reach the cash markets in July, the scarcity eased and prices dropped, though they remained above the old levels, perhaps in an effort to "ration" the wheat supply over the coming year.

      But the speculator following Principle #2 didn't have to know any of this (though it would have helped confirm the signals). Whatever the reason for the price move, the observation that one must make is that after a period of relative stability, once prices move out of that narrow range they normally tend to continue to move in that direction for several days, weeks, or months. This is an essential market observation which will be of the utmost importance to you as a commodity futures trader. While it may seem too simple, you should remember that something need not be complex for you to make money from it. A great many people have lost their shirts in the commodity markets precisely because their approach or analysis was too complicated.

      It is impossible to forecast all commodity price fluctuations, or even the majority of them. So, rather than attempt to trade all the markets all the time, some speculators limit trading to a particular price pattern that has shown itself consistently to be profitable. My experience in 15

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