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My Lessons From The Commodity Pits

Futures are not Stocks – Don’t Treat Them the Same!

Even in today’s digital age, the noisy, fast-moving trading pits can still be found around the world for buying and selling hundreds of commodities. It’s a direct decedent from the barter system of ancient times where merchants would meet at an agreed-upon price & location in order to transact business for the delivery of goods.

I had the privilege of spending every day on the floor of the Chicago Mercantile Exchange for 18 months as a technical analyst helping our firm’s traders identify commodity price trends to set buy and sell points. I can say that the lessons learned “in the pits” rival the knowledge gained in my MBA courses and help me become a successful money manager.

With the possibility of a high inflation cycle around the corner, many investors are looking at adding commodity futures exposure to their portfolios. Since it’s one of the least understood financial mediums, there are many issues to consider before conventional investors forge ahead.

Fact #1: Futures are not Stocks

You do not “invest” in commodities but can “trade” everything from carbon emissions to butter. Each futures contract (called “cars”) covers a specified price & amount of the commodity to be delivered at a specified date (usually within 90 days). Buyers and sellers never meet each other, and the holder of a futures position can sell the contract before maturity or pay the full price and physically take delivery of the commodity on maturity. Most commodity contracts are traded by speculators and are “closed out” prior to the maturity date.

Fact #2: Strong Performance During High Inflation

Since commodities are not designed to be long-term investments, it is difficult to directly compare their long-term performance to investments such as stocks, bonds and real estate. However, it can be easily proven that commodities perform well during times of high inflation (such as the 1970’s). In fact, the CRB Futures Index was up 140% while the DJIA barely budged – only up 2.4% during that inflationary decade (see charts).

Chart 1: CRB Futures Index, 1970’s Chart 2: Dow Jones Industrial Average, 1970’s

Fact #3: Only for Serious, Disciplined, Experienced Investors

Futures can provide investors a liquid, high leveraged way to speculate in commodity bull markets (high demand & low supply) or bear markets (low demand & high supply). Yes, fortunes have been made commodities trading!

However, high leverage is a two-edged sword! Volatile swings in the value of a brokerage account can occur in both directions and quickly wipe out a poorly managed portfolio. Because of this, both the exchange and investment firms require the purchaser/seller of a futures contract to commit and maintain sizable cash deposits equal to margin requirements as low as 10% (compared to stock investments with a maximum of 50% initial margin).

Recently, Wall Street started offering a wide array of commodity ETF’s. It’s too early to tell if these financial mediums are for the average investor since they can be illiquid, very volatile and offer limited choices on the short side during bear markets.

History has shown that futures are not the best choice for investors who like to only maintain “long” positions with “loose” stop loss orders. Successful commodity traders are equally skilled at handling bull and bear markets and are comfortable with the fact that most of their trades will result in a minor loss.

Fact #4 The Technicians World

If you don’t like charts, stay out of commodities! Most of the tools used by practitioners of technical analysis (ranging from moving averages to advanced statistical models) have their roots in commodity trading in the late 1800s where hyper monitoring of price action and setting stop loss orders was required to prevent financial disaster. Before hiring an advisor to help you with commodities trading, make sure they are a “Chartered Market Technician” (CMT).

If high inflation has returned, investors are going to need to adjust their investment strategies and adding futures trading into the investment mix might become essential to make money in the 2020s.

Humor can be a good teacher! Before jumping into “Pork Bellies” or Frozen Orange Juice, my advice is to watch the 1980’s financial comedy, “Trading Places”.

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