While most investors are exclusively familiar with trading stocks such as stocks or mutual funds, or investing in debt instruments such as bonds, commodity trading is usually ignored despite the fact that it has many advantages over other types of investment vehicles. Let’s start by defining what a “product” is in the first place. Products can be of different shapes. The most commonly traded commodities are lean pigs, live cattle, oats, wheat, metals and even currencies.
One of the attractive things about commodity trading is the ability to generate large profits in a fairly short period of time. However, commodity trading is viewed by most as extremely risky as most investors tend to lose money. However, by doing your due diligence and determining whether the item you are interested in is undervalued or overvalued, say if you want to go long or short respectively, you can minimize the risk associated with trading commodities. It can also be helpful to have an experienced trader by your side to guide you.
When you trade commodity futures, you don’t actually buy or own anything, unlike other types of investments like stocks or bonds. You are just thinking about where the price of a given product will go. If, after researching, you believe that the price of coffee will rise, you will buy future contracts or go long. On the other hand, if you were under the impression that the price of sugar would fall, you would sell futures contracts or go short.
As mentioned earlier, you can also buy currency futures or market indices in addition to buying or selling futures for commodities such as cattle and pigs. One of the benefits of trading market index futures is that you don’t have to invest a lot of money, as opposed to having to invest a significant chunk of capital if you buy individual stocks. Let’s illustrate this: A $ 10,000 futures contract on the Nasdaq is equivalent to approximately $ 200,000 in stock. Suppose you expect the market to rise soon, you can potentially buy many of the stocks in the Nasdaq stock index (herd thinking), or you can buy a futures contract on the Nasdaq. Suppose you invested $ 200,000 in Nasdaq stock, and if the index rose, you would have made a profit of, say, $ 25,000. However, if you had instead simultaneously bought a $ 10,000 futures contract, instead of investing $ 200,000, you would have earned the same $ 25,000 by investing much less capital in the first place.
The downside to commodity trading is that it is usually done on margin to boost your investment, so a small price cut could potentially cost you all of your investment. It is for this reason that a person must exercise due diligence and decide for himself whether a given futures contract is a wise investment. While commodity trading can be fun, albeit unsafe, it offers investors another way to diversify their investment portfolios.