The Fundamentals of Commodities Trading Undergraduate Investment Society, Meeting 2

What are commodities? •  Commodities are raw materials used to create the

products consumers buy, from food to furniture to gasoline.

•  Commodities include agricultural products such as wheat and cattle, energy products such as oil and gasoline, and metals such as gold, silver and aluminum.

•  There are also “soft” commodities, or those that cannot be stored for long periods of time, which include sugar, cotton, cocoa and coffee.

Some common commodities traded

What are the exchanges that trade commodities? • CME Group – Agricultural (Corn, Soybeans, Soy

Products, Wheat, Pork, Cattle, Butter, Milk, Metals (Gold, Silver)

•  Intercontinental Exchange (ICE Futures Europe – Energy, including crude oil, heating oil, natural gas and unleaded gas

• & Many more!

But I don’t want to lug around gold bars…

•  You don’t have to! The commodity market has evolved significantly from the days when farmers would haul bushels of wheat to the local market.

•  In the 1800’s, demand for standardized contracts for trading agricultural products led to the development of commodity futures exchanges.

•  Today, futures and options contracts on a huge array of agricultural products, metals, energy products and soft commodities can be traded on exchanges worldwide.

What are futures contracts? •  The buyer of the futures contract (long position) agrees

on a fixed price (the futures price) to buy the underlying commodity from the seller at the expiration date (delivery date) of the contract.

•  The seller of the futures contract (short position) agrees to sell the underlying commodity to the buyer at expiration at the fixed sales price.

•  Futures contracts are not ‘direct’ securities like stocks or bonds; they are derivatives, meaning that their performance is based on an underlying asset (commodity).

Why trade commodities futures? •  Real life example!

▫  You decide to subscribe to cable television. As the buyer, you enter into an agreement with the cable company to receive a specific number of cable channels at a certain price every month for the next year.

▫  Similar to a futures contract: you have agreed to receive a product at a future date, with the price and terms for delivery already set.

•  Why do it? You have secured your price for now and the next year - even if the price of cable rises during that time. By entering into this agreement with the cable company, you have reduced your risk of higher prices.

•  Back to commodities:

▫  A producer of wheat may be trying to secure a selling price for next season's crop, while a bread maker may be trying to secure a buying price to determine how much bread can be made and at what profit.

▫  The farmer and the bread maker may enter into a futures contract requiring the delivery of 5,000 bushels of grain to the buyer in June at a price of $4 per bushel. By entering into this futures contract, the farmer and the bread maker secure a price that both parties believe will be a fair price in June.

Commodities are traded on margin: it’s a surefire way to gain or lose big!

•  1,000 barrels of oil/contract

•  Buy contract at $80/bbl, 10% margin

▫  $80,000/contract = $8,000 (the contract) + $72,000 (Cash on Delivery)

•  Price of oil rises to $81/bbl

▫  $81,000/contract= $8,100(the contract) + $72,900(C.O.D.)

Oil and gold is where it’s at! (also what we will be trading)

How can you invest in commodities? •  You might not be able to…

•  Before a brokerage will let you invest in commodities, you’ll have to meet certain net worth requirements and put cash in a brokerage margin account.

•  The commodities market is wildly unpredictable: you can make lots of money or lose everything in hours, if not minutes.

▫  The Commodity Futures Trading Commission describes commodities trading as a "volatile, complex, and risky business.”

What is a safer way to get into commodities?

•  Invest in a mutual fund that buys and sells commodity futures.

▫  Pimco Commodity Real Return Strategy D (Ticker: PCRDX) caps its energy holdings at 33% and tries to diversify (by investing in gold, for example)

▫  The Oppenheimer Real Asset fund (Ticker: QRAAX) tries to mimic the GSCI ▫  Goldman Sachs Commodity Index (GSCI) is a composed of twenty-two different

commodities in a proportion that reflects the value of their production in the world economy.   This means that energy futures make up around 55% of the GSCI and agricultural

commodities make up around 25% of the index.

•  Or invest in an exchange-traded fund (ETF) that is tied to the price of a commodity (like gold, for example)

▫  StreetTRACKS Gold Shares (GLD) ▫  iShares COMEX Gold Trust (IAU) ▫  iShares Silver Trust (SLV)

How to choose the right mutual fund (tips from the SEC) •  Scrutinize the fund's fees and expenses ▫  For example, if you invested $10,000 in a fund that

produced a 10% annual return before expenses and had annual operating expenses of 1.5%, then after 20 years you would have roughly $49,725. But if the fund had expenses of only 0.5%, then you would end up with $60,858.

•  Consider the fund's portfolio turnover rate •  Think about the volatility of the fund by looking at

past performance •  Assess how the fund will impact the diversification

of your portfolio

Or, invest in stocks with stakes in specific commodities •  FCX – explores and mines copper and gold •  SBUX – roaster and retailer of specialty coffee

•  It is also useful to hedge against inflation with commodities

Intent on trading commodities? •  Some strategies: ▫  Know when to cut your losses.

  Place a stop-loss order with instructions to exit a trade if the market hits your loss limit.

▫  Know when to let your profits run.   Place a trailing stop some distance behind your trade.

Choose a % of the profit you have already accumulated, and then use the trailing stop to protect that.

▫  Diversify! Don’t put all of your money into one commodity   Consider buying contracts from different months to

hedge risk – Buy April and sell May contracts to protect against huge losses, for example

CME Commodity Trading Competition

•  Products Traded: Crude Oil and Gold Futures •  Practice Round: February 14-16, 2011 •  Preliminary Round: February 16 - March 3, 2011 •  National Finals: March 6-18, 2011

•  If you would like to participate in the competition, please let Melanie or Roy know ASAP.

NOTE: Five members per team, two teams possible if there is enough interest