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The Market Guys

Capturing Profits in the Commodities Markets*

By AJ Monte & Rick Swope
TheMarketGuys.com

Many people have turned on the financial programs and have heard experts talk about the commodity markets but few actually understand the mechanics behind commodities trading and how these markets drive the world economy. Commodities and futures contracts were traded long before the stock market was ever created yet they are one of the least understood investment instruments in the world.

In an effort to give you the tools needed to profit in such markets, we will need to first explain exactly what a commodity contract looks like. A commodity is anything for which there is demand, mainly basic resources and agricultural products that include iron ore, crude oil, coal, ethanol, sugar, coffee, beans, soybeans, aluminum, rice, wheat, gold and silver. One of the characteristics of a commodity good is that its price is determined as a function of its market as a whole. These days one of the most watch commodities is crude oil. Without question, this commodity has caused more volatility in the world's economy that most others combined, yet the average investor knows little about how to profit in this market.

Many years ago farmers came up with a way to connect investors to their crops in an effort to cut down on the risk of price fluctuations. Before the commodity exchanges were created it was the farmer who assumed the risk of price movement between the time they planted their crops to the time they harvested those crops. If you were a farmer who planted a soybean crop and things were going well for you, with regard to weather conditions, environmental issues and it looked as though the yield for this crop was strong, you would still be taking enormous risk holding on to this crop should the price of soybeans drop prior to your being able to bring your soybeans to market. Early investors decided that they would be willing to assume the risk of a dropping market as long as they were given the chance to make a profit should prices rise in this same time period. Hence, the futures contract was created.

A futures contract is nothing more than a standardized contract or agreement to buy or sell a certain underlying commodity at a certain date in the future, at a specified price. The future date is called the delivery date, or settlement day, and the pre-set price is called the futures price. If we were looking at this through the eyes of a farmer and an investor, a futures contract gives the holder the obligation to buy or sell that particular commodity.

Example:

1. The farmer has agreed to deliver his crop on a certain date to an investor who is willing to buy that crop at a certain price. This price is determined long before the crop has even been harvested. The investor has not paid for the crop yet but has simply agreed that they would buy that crop when the time comes.
   
   
2. The farmer is happy because he is guaranteed to get a fair price for his crop even if the price of soybeans drops between the time this contract is traded and the time of harvest. The investor is now assuming all of the risk should the price of soybeans fall.
   
   
3. The investor now has full control over this crop even though he has not paid for it in full. Should the price of soybeans rise between now and the time of harvest, the investor is in a position to make a big profit because he has also locked himself into a buy price long before the soybeans have been harvested.
   
   

Another way to look at this relationship between the investor and farmer is to take something we are all familiar with and compare the similarity between a commodity investor and a real estate broker.

A real estate broker has something to sell, which is real estate (think of this as a soybean crop). This real estate broker is in a position that is similar to the farmer in that as prices go up and down in the real estate market the broker is exposed to price fluctuations for as long as they are holding on to the property. So along comes an investor who is interested in buying this property believing that real estate prices will go up in value over the next few years. This investor signs a contract that locks in a specified price for this property on a certain date that we call the closing date. The closing date very similar to our settlement date in the futures markets. It's the date on which the transfer of property is made.

If you look at the similarities between the farmer and the real estate broker you will see that once the contract has been signed a binding agreement has been made to deliver something. In the case of the farmer it is soybeans, in the case of the real estate broker it is property. Looking at the investors who participated in these two markets you will also see that they share the same opportunities to profit. Should the price of real estate go up during the time the contract is signed to the time at which the deal is closed the real estate investor will make a profit just like the investor in the soybean futures contract.

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*This article ("Article") has been written and provided by The Market Guys, an independent third party that is not affiliated with E*TRADE Canada Securities Corporation ("E*TRADE Canada") or its affiliates. The Article is provided to you for informational purposes only. No information contained in the Article has been endorsed or approved by E*TRADE Canada, and E*TRADE Canada is not responsible for the content thereof or for any third parties (including The Market Guys), or for any third party opinions, products or services. E*TRADE Canada does not provide investment advice or recommendations and you will consult with and rely upon your own advisors. You are fully responsible for your investment decisions and any profits or losses that may result.