Commodity Futures Chapter 15 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company1 What is it? A commodity purchase represents ownership of a definite physical item. –Includes: Sugar, wheat, corn, lumber, pork bellies orange juice, cotton, cocoa, coffee, eggs, etc. The purchaser is buying the actual item itself. –Not a paper ownership right. –The units of purchase are measured by given weights, sizes, or shapes.

Commodity Futures Chapter 15 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company2 What is it? Most investors purchasing commodities buy a contract to either make or accept a delivery of a specified commodity on a given future date. –Thus the term “futures contract” –If the contract runs to its termination, the investor must complete the contract by either making a delivery of the commodity or paying cash in acceptance of the commodity.

Commodity Futures Chapter 15 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company3 When is the use of this tool indicated? When the investor is willing to take very high risks. –The potential rewards of commodities trading are extremely high. –Over 70% of commodities speculators will lose money. –Aggregate losses are typically five to six times greater than gains. When the investor is able to risk at least $10,000 of capital. –This is the suggested minimum necessary to allow reasonable diversification of positions. –The investor must be able to respond to “margin calls.” Margin: An amount of money deposited by both buyers and sellers of futures contracts to ensure performance of the terms of the contract. A brokerage firm may “call” for additional margin to bring the funds in a customer’s account up to the required level.

Commodity Futures Chapter 15 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company4 When is the use of this tool indicated? When the investor desires a very high degree of leverage in his investments. –There are low margin requirements on commodities investments. An investor can finance 90% to 95% of the value of the contract at the time of purchase. The margin is considered a security deposit. The investor pays no interest on the unpaid balance in the contract. When the investor has the emotional stability to accept frequent and possibly significant losses. When the producer of a particular commodity would like to “hedge” one risk by taking an offsetting one.

Commodity Futures Chapter 15 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company5 Advantages A speculator in commodities has the potential of making enormous profits in a relatively short period of time. For a given investment budget, the extremely low margin requirements for commodities permit more diversification than would be possible in the stock and bond markets. Producers of various commodities can transfer the risk of price changes to speculators and lock in a particular price when they bring their commodity to market.

Commodity Futures Chapter 15 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company6 Disadvantages An investor’s position can be completely wiped out by a relatively small change in the price of the commodity. This is due to: –The very low margin requirements of the contract –The inherent volatility of the commodity markets Positions in commodities are “marked-to-the-market” on a daily basis –At the close of trading each day, the clearinghouse for the exchange calculates the gains and losses on all open positions and transfers those gains or losses into or out of all margin accounts. Profits may be withdrawn by an investor, but losses are deducted immediately from the investor’s account. A “margin call” may be issued if the remaining margin declines below the level of the required maintenance margin.

Commodity Futures Chapter 15 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company7 Disadvantages Each commodity has a daily price limit. –Once that limit is reached, trading stops for the day. –Investors can be “locked in” to a position.

Commodity Futures Chapter 15 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company8 Tax Implications Net gains on all speculative commodity futures contracts are taxed at a maximum effective rate of 23%. –Net gains on all speculative transactions are treated as though they are 40% short-term capital gains and 60% long-term capital gains. All “open” positions at the end of the tax year are treated as if they had been closed on the last day of the year. –Any gain or loss inherent in a futures contract at the end of the year (or at any time during the year) must be reported annually, even if the investor has not actually realized those gains or losses.

Commodity Futures Chapter 15 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company9 Tax Implications Net future trading losses may be applied against the investor’s other capital gains –If a net loss on futures transactions still exists, these may be carried back three years. –Any leftover is carried forward indefinitely.

Commodity Futures Chapter 15 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company10 Alternatives An investor may purchase shares in a mutual fund that specializes in commodities. –These funds offer professional management and the constant attention demanded by the volatile market. A “commodity” pool is an alternative to mutual funds. –Individuals purchase units in the pool. Their money is combined and invested in a number of active commodities. –In many cases the pool will be closed out when 50%of the original capital is lost. –They are normally structured as limited partnerships requiring a minimum investment of $5,000 or more. They typically require that investors have a minimum income and wealth position.

Commodity Futures Chapter 15 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company11 Where and How do I get it? Investors may trade contracts on commodities through their brokerage firms. –A separate margin account is required. –Settlement on this account is made on a daily basis. Investors may take part in a “managed account” program. –A commodities broker has the discretionary power to trade for the investor’s account. –The broker may participate in the profits earned on the account in addition to any commissions generated by the trading activity. Commodity mutual funds may be purchased through a broker or directly from the fund itself. –Minimum investments generally range from $1,000 up to $10,000. –Advantage: Individuals can participate in a portfolio of commodity contracts with increased diversification.

Commodity Futures Chapter 15 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company12 What fees or other costs are involved? A commission or service charge is applied to a commodities trade in much the same fashion as the buying or selling of stocks and bonds.

Commodity Futures Chapter 15 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company13 How do I select the best of its type? Investors should concentrate their attention on a few commodities rather than spread their investment over a large number of different contracts. –More time and effort will be needed to follow commodity positions than similar investments in stocks and bonds. –The average investor will generally be less knowledgeable about commodity markets. Select markets that are active and that have a large “open interest.” –Example: The number of contracts in a commodity that have not been closed out, exercised, or allowed to expire. –Beginning investors should avoid “thin” markets. These are especially prone to volatile price swings because of the relatively low number of contracts and active traders.

Commodity Futures Chapter 15 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company14 How do I select the best of its type? Inexperienced traders should begin with a conservative position of one or two contracts that mature in a distant month. –This requires a relatively small investment. –It also gives the investor time to study the market and get better acquainted with its characteristics before making greater commitments. –Buying contracts in distant months will reduce the amount of trading and the amount of commissions charged. It is generally a good idea to put in a “stop-loss order.” –5% below the market price when buying a commodity, and 5% above the market for a short sale. –This limits the investor’s losses while allowing for continued gains if the market moves in the anticipated direction.

Commodity Futures Chapter 15 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company15 How do I select the best of its type? Never put up additional margin to maintain a contract. –A request to do so indicates that the market is moving against you and will likely continue to do so. –It is better to liquidate your position and take a small loss rather than continue to increase your investment and risk a major loss of capital. Investors should look for a firm with a strong background in commodities, and deal with a broker who is a specialist in the field. –It is not likely that a broker whose area of expertise is stocks and bonds will also be knowledgeable in the area of commodities. –Diversified investors may want to maintain a separate brokerage account for their commodities trading activity.

Commodity Futures Chapter 15 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company16 Where can I find out more about it? Wall Street Journal and other major newspapers –Offer daily price quotations on various commodities. Major brokerage firms –Those with departments that specialize in trading commodities may be a source of reports and charts on the various commodity contracts. Technical Analysis of Stocks and Commodities Magazine –Published monthly by Technical Analysis, Inc. (store.traders.com) The Chicago Board of Trade ( –Publishes a reference book entitled, Commodity Trading Manual –The website has a wealth of information on physical commodities and financial products.