Commodities

The Smart Profits Report: Issue #114
Thursday, May 27, 2004

Commodities: How to Create Your Own ‘Mini Hedge Fund’
By Karim Rahemtulla
Investment Director, Mt. Vernon Research

The stock market still gets most of the press, but the financial media is finally waking up to the roaring bull market in commodities.

It’s about time…

Since the beginning of 2002, stocks have returned negative 0.9% - even with the 2003 rally. On the other hand, the CRB Index of commodity prices is up 46% and individual commodities have done even better.

Gold is up 51%
Silver is up 81%
Copper is up 101%
Soybeans are up 146%

Many investors have tried to profit from the commodity bull by buying commodity-based stocks. The problem is, owning a commodity stock does not necessarily mean full (or even partial) participation in a rally of the underlying commodity. Crude oil has rallied 66% since the beginning of 2002, but Exxon Mobil has only rallied 6% in the same time frame. For other commodities there is simply no stock alternative.

Direct Commodity Plays: Major Profits at a Serious Discount

Both futures and futures options enable the individual investor to make direct plays on commodities, currencies, interest rates and stock indexes for a fraction of the cost of more traditional investments.

That’s why professional traders use them.

For example, if you own an index fund, the odds are good you are probably already trading futures in your fund. Why? Because it is perhaps the cheapest way for a fund manager to mimic index performance.

Similarly, you can use long-dated futures options to create your own “pennies on the dollar” mini hedge funds in crude oil, metals, grains, currencies and virtually every major asset class, for a fraction of what it would cost you to do so with stocks or actual hedge funds. However, before you get to futures options, you need an understanding of futures contracts themselves.

Anatomy of a Futures Contract

A commodity or “futures” contract is an agreement between two people. The “seller” of a futures contract agrees to deliver a specific item to the “buyer” of the contract for a certain price on a fixed date in the future. The buyer of a futures contract agrees to take delivery of the same item under the same terms. The buyer of a futures contract is said to be “long” the market. The “seller” of a futures contract is said to be “short” the market.

Futures contracts are essentially “paper transactions” in that they do not involve the purchase and sale of the actual investment instruments themselves. They are contracts for delivery at a specified future date. Because no delivery takes place prior to a specified period, no money actually changes hands. Consequently, the buyer of a futures contract does not have to pay money for goods received, and the seller of a contract does not receive any money for them.

As long as the buyer of a futures contract offsets his contract before the delivery date by selling it, he will not receive delivery of the commodities (or currency, or basket of stocks) he has contracted to take delivery of, and will not have to pay for them. His profit or loss is the difference between the price he paid for his futures contract and the price at which he sold it, multiplied by the contract size.

Ditto for the seller… As long as the seller of a futures contract offsets her sale by buying it back before the delivery date, she will not have to make delivery of the underlying commodity, currency or basket of stocks. Her profit will be the difference between the price she sold the contract for and the price at which she buys it back.

How to Go Short or Long with Equal Ease

The treatment of long and short futures positions is identical. Unlike a short seller in stocks, the seller of a futures contract does not need to “borrow” his contract from another party. This makes it just as easy to sell as to buy.

Contract sizes are set by the different exchanges and are fixed. Barron’s, The Wall Street Journal and The New York Times list the contract sizes of major U.S. futures contracts. Most futures contracts trade thousands of contracts per day, with many trading well in excess of 10,000 contracts per day, making futures liquid and just as easy to buy and sell as most stocks.

Consider one of the more popular futures contracts: oil.

Let’s say Joe buys a 1,000-barrel crude oil futures contract traded on the New York Mercantile Exchange (NYMEX) for a price of $30 per barrel… and Sue sells a 1,000-barrel NYMEX crude oil contract at the same price of $30 per barrel. If prices rise 10%, to $33 per barrel, Joe’s profit would be $3,000, or $3 times the contract size of 1,000 barrels. Conversely, Sue would lose $3 per barrel, or $3,000 per contract.

Similarly, a drop of 10%, or $3 per barrel, would make buyer Joe $3,000 poorer and seller Sue $3,000 richer.

And keep in mind: Because their positions were entered before the delivery period, buyer Joe never had to pay for the crude oil and seller Sue never received any money for it. So how did they “pay” for their transactions?

They didn’t.

What they did was post performance bonds with their respective commodity brokers in the form of “margin.” We’ll cover margin in our next installment. Until then…

Good trading,

Karim Rahemtulla