What Is Commodity Futures Investing?

A brief overview of commodities as investment vehicles.

If you are drinking a cup of coffee while you are reading this article, you have participated in the commodity futures market. More accurately, you are drinking the results of a commodity futures contract that has expired when a coffee company bought the coffee beans from a grower at a contracted price.

The commodity futures market was originally set up to allow buyers and sellers of commodities - such as coffee beans, oil, soybeans, pork bellies (bacon to you and me) - to buy and sell with some sense of confidence that the notorious fluctuations in commodity prices can to some extent be leveled by buying and selling "contracts" on the goods sold. If you were a grower of coffee beans and you sold a contract on beans to be delivered at a specific price at a specific time in the future, you protected yourself if the price of coffee beans dropped between the time you start your growing season and the time when you must sell your beans. You also, however, didn't earn as much if the price of the beans rose. It's a gamble, but it's a gamble worth taking if you are trying to hedge your loss against potential gains for your product.

The time between when a futures contract is first sold for a commodity and when that commodity is finally delivered at market is the time for commodity futures investing. If you feel the value of a commodity will rise, you can buy a futures contract promising to sell at today's price and sell it later at the higher price. If the price falls, you will be selling at a loss.

The simplicity of the idea for commodity futures contracts, however, does not match the complexity of how investing in futures really works. This is the land of do-or-die where fortunes can be made and lost rapidly.

Commodity futures contracts are sold on margin. This means that you need to only put up a small percent of the true value of the commodity you are promising to buy or sell at the agreed upon price. The regulators of the futures market set the amount of margin you need to pay with the more volatile commodities requiring a larger margin payment.

This works very well for you if the price of the commodity moves in the direction you hoped for. For example, if the price of your commodity - coffee beans or pork bellies - goes up 1%, the value of your contract could increase 50% or 60%. Buying on margin means that your small margin payment rides on the back of the much larger value of the underlying commodity.

Of course if the price moves in the wrong direction, your loss will be just as great.

As with any investment, information is key. With volatile commodity prices, this is an absolute necessity. Weather conditions, interest rates, political instability - or even the possibility of changes in these conditions - can lead to rapid and steep price changes.

To invest in commodity futures, you need a broker to fill your orders. Most experts insist that your capital be large enough to withstand great losses. Some brokers won't accept clients with less than $10,000 to invest, others require hundreds of thousands.

If you don't want to feel that you're playing roulette in your commodities investing, a way to begin is to set up a paper account - no real money but lots of practice. Know your markets before committing your money. When should you put in a market order to buy at the price then available, a limit order to set a limit on price, or a stop order to set a price to buy or sell a contract? How many contracts can you handle at once?

Two places to start you education on commodity futures investing might be to contact the regulators and see what you can learn from them.

National Futures Association

200 W. Madison St.

Chicago, IL 60606

(800) 621-3570

Commodity Futures Trading Commission

2033 K Street NW

Washington, DC 20581

(202) 254-8630

Finally, don't forget to offset your futures contract before it expires by either buying or selling to counter balance your contracts. Otherwise you will be having your coffee with lots of coffee beans.

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