The majority of the investors are only familiar with equity trading, such as stocks or mutual funds, or investing in debt, such as bonds.
Investing in commodities and commodity trading tend to be ignored despite the fact that they have many advantages over all other types of investment instruments.
Let’s begin by defining what a “commodity” is in the first place.
Commodities can come in many forms.
Most commonly traded commodities include i.e. lean hogs, live cattle, oats, wheat, metals, and even currencies.
One of the attractions of trading commodities is the potential for gaining large profits in a considerably short period of time.
Nevertheless, commodity trading is considered by most as being extremely risky since most investors tend to lose money.
However, by performing your due diligence and determining whether the commodity that you’re interested in is either under or overvalued, say if you want to go long or short, respectively, you may be able to minimize the risk involved in commodity trading.
It may also help to have an experienced commodity trader by your side to guide you.
When you’re trading commodity futures, you’re not truly purchasing nor owning anything, unlike other types of investments, such as stocks or bonds.
You’re simply speculating on where the price of a given commodity will be headed.
If, after doing your research, you believe that the price of i.e. coffee is going to rise, you would purchase future contracts, or go long.
On the other hand, if you were under the impression that the price of sugar was going to drop, then you would sell future contracts, or go short.
As I mentioned earlier, one can also purchase futures in currency or market indices, in addition to buying or selling futures on commodities like cattle and hogs.
One advantage of trading futures on market indices is that you don’t need to invest a lot of money, as opposed to having to invest a considerable chunk of capital if one were to purchase individual stocks.
Let me provide an example:
A $20,000 futures contract on the Nasdaq is equivalent to about $400,000 dollars in stock.
Let’s assume you expect the market to rise shortly, you could potentially buy many of the stocks that form part of the Nasdaq stock index or you could purchase a Nasdaq futures contract.
Suppose you invested $400,000 in stocks in the Nasdaq, and if the index had risen, you would have made a profit of say, $50,000.
On the other hand, if you instead purchased a $20,000 futures contract simultaneously, rather than investing $400,000, you would have made the very same $50,000, by investing with a lot less capital in the first place.
A disadvantage to commodity trading is that it is usually done on margin in order to leverage your investment, so a small drop in the price could potentially cost you your whole investment.
It is for this reason that one must perform his own due diligence and decide for himself if a given futures contract will be a prudent investment.
Although commodity trading can be fun, albeit not without risk, it offers investors another way to diversify their investment portfolios.