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Chapter 15 Commodity futures.

WHAT IS IT?

A commodity purchase represents ownership of a definite physical item such as sugar, wheat, corn, lumber, or pork bellies. Other commodities include orange juice, cotton, cocoa, coffee, and eggs. The purchaser is buying--not a paper ownership right--but the actual item itself. The units of purchase are measured by given weights, sizes, or shapes. For example, a wheat contract may be described as "No. 2, soft red winter wheat" and each contract represents a 5,000 bushel purchase.

Most investors purchasing commodities buy a contract to either make or accept a delivery of a specified commodity on a given future date--thus the term "futures contract." If the contract runs to its termination, the investor must complete the contract by either making a delivery of the commodity or paying cash in acceptance of the commodity.

Despite stories of carloads of wheat or corn being dumped on someone's lawn, the vast majority (96%+) of commodity futures contracts are "closed out" before they mature.

WHEN IS THE USE OF THIS TOOL INDICATED?

1. When the investor is willing to take very high risks. Although the potential rewards of commodities trading are extremely high (it is possible for an investor to double his money in only a few days), over 70% of commodities speculators will lose money, and aggregate losses are typically five to six times greater than gains. If a commodities contract is allowed to expire (for example, because the price of soybeans plummets from $13 to $5, and the investor's contract allows him to purchase soybeans at $10 per bushel), the investor has no equity, his entire position is eliminated, and the value of his contract is zero.

2. When the investor is able to risk at least $10,000 of capital. This amount is the suggested minimum necessary to allow reasonable diversification of positions, and to respond to "margin calls." Margin is an amount of money deposited by both buyers and sellers of futures contracts to ensure performance of the terms of the contract. A brokerage firm may "call" for additional margin to bring the funds in a customer's account up to the required level.

3. When the investor desires a very high degree of leverage in his investments. This leverage comes from the low margin requirements on commodities investments. Compared to margins of 50% when investing in common stocks, margins on commodity investments are extremely low. An investor can finance 90% to 95% of the value of the contract at the time of purchase. (The actual cash required will vary according to the commodity and the standards of the broker handling the transaction.) The margin for commodities is considered a security deposit. Therefore, unlike margins for securities that are interest bearing, the investor pays no interest on the unpaid balance in a commodities contract.

4. When the investor has the emotional stability to accept frequent and possibly significant losses. Clearly, commodities trading is not for the fainthearted.

5. When the producer of a particular commodity would like to "hedge" one risk by taking an offsetting one. For example, assume a farmer plants winter wheat. He has calculated that he must receive a price of $ X.XX per bushel to break even. Yet, he has no assurance of what the price will be when he is ready to bring the wheat to market. To assure himself of at least a minimum price he enters into a futures contract guaranteeing a price of $ Y.YY per bushel upon delivery of the wheat.

If the cash market price is below the price guaranteed in the futures contract, the farmer will exercise the contract, deliver the wheat, and obtain his expected profit. Conversely, if the cash price is above the contract price, the farmer will likely sell his wheat in the cash market, buy back his futures contract, and presumably increase his profit.

In essence, the commodities exchange serves the function of finding someone to complete the opposite side of the contract. That someone is the investor (speculator). This individual assumes the risk because he feels he can profit from price movements on wheat before the delivery date of the contract. For example, the speculator may feel that wheat prices will rise sharply in the next few months, and that there will be a corresponding increase in the value of his contract (because the contract gives him the right to buy wheat at a fixed price below the expected market price).

ADVANTAGES

1. A speculator in commodities has the potential of making enormous profits in a relatively short period of time. Assume corn is selling at $2.90 per bushel and an investor purchases one 5,000 bushel contract. Instead of putting up $14,500, he is allowed to deposit only $1,000. If the price of corn rises to $3.19 (a price change of only 10%), he will have made a profit of $1,450 ($0.29 x 5,000 bushels), less commissions. But, if we compare his profit of $1,450 to his outlay of $1,000, the percentage return is 145% (lowered slightly by commissions).

2. For a given investment budget, the extremely low margin requirements for commodities permit more diversification than would be possible in the stock and bond markets.

3. Producers of various commodities can transfer the risk of price changes to speculators and lock in a particular price when they bring their commodity to market.

DISADVANTAGES

1. An investor's position can be completely wiped out by a relatively small change in the price of the commodity. This is due to the very low margin requirements of the contract, and the inherent volatility of the commodity markets. In the example above, the investor purchased a 5,000-bushel contract for corn selling at $2.90 per bushel. Instead of putting up $14,500 ($2.90 x 5,000), his broker allows him to deposit only $1,000. If the price of corn were to drop by twenty cents per bushel, the value of the contract would have declined by $1,000 and his margin would have been eliminated. This would result in a call from his broker for additional margin in order to maintain his position.

It is very likely that an investor who puts up small amounts of margin will often have that margin eliminated. Unless the investor is willing to put up additional margin, his position will be "closed out" and the contract terminated. This may occur a number of times before the investor will be able to discern and follow a trend in the market.

2. Unlike other securities markets, positions in commodities are "marked-to-the-market" on a daily basis. This means that at the close of trading each day, the clearinghouse for the exchange calculates the gains and losses on all open positions and transfers those gains or losses into or out of all margin accounts. Profits may be withdrawn by an investor, but losses are deducted immediately from the investor's account. If the remaining margin declines below the level of the required maintenance margin, a "margin call" will be issued asking that additional funds be added to the account to bring it back to the minimum margin level. Should the investor fail to do so, his position will be "closed" by the firm handling his account. In other words, the brokerage firm will terminate the investor's interest in the contract. It does this by either buying or selling an offsetting contract.

3. Each commodity has a daily price limit, and once that limit is reached trading stops for the day. For example, the maximum daily price movement for soybeans, one of the most active commodity markets, is twenty cents per bushel. This represents a value of $1,000 per contract on a 5,000 bushel contract. The purpose of this limit is to protect the commodity markets from severe price fluctuations that could result from news of crop damage, weather reports, and other natural or market occurrences. This restriction on trading can cause the investor to be "locked in" to a position when the market is unavailable to buy or sell the commodity.

For instance, Mary Satin owns a futures contract for wheat. A newly issued crop report indicates a tremendous surplus that causes a panic in the market. Prices fall sharply, and before Mary can act, the drop in price has reached the maximum daily limit. That causes all trading in wheat to stop and Mary is forced to hold her contract until trading resumes. By that time it may be even more difficult to close out her position.

TAX IMPLICATIONS

1. Net gains on all speculative commodity futures contracts are taxed at a maximum effective rate of 23%. This is due to the fact that net gains on all speculative transactions are treated as though they are 40% short-term capital gains and 60% long-term capital gains. Applying the maximum tax rate of 35% (in 2004) and a 15% capital gains rate results in a 23% overall rate ((35% x 40%) + (15% x 60%)).1 The usual holding period rule for determining whether a gain or loss is short-term or long-term is ignored.

2. All "open" positions (those that have not been closed out, exercised, or that have expired) at the end of the tax year are treated as if they had been closed on the last day of the year. In other words, any gain or loss inherent in a futures contract at the end of the year (or at any time during the year) must be reported annually, even if the investor has not actually realized those gains or losses. Therefore, if a contract has not been terminated or transferred before the end of the tax year, it is artificially treated as though the investor had sold it for its fair market value on the last business day of the year. Profits or losses from these open positions are combined with those positions that were actually closed during the rest of the year.

3. Net futures trading losses may be applied against the investor's other capital gains. If a net loss on futures transactions still exists, these may be carried back three years. If any loss still remains it may be carried forward into succeeding years.

ALTERNATIVES

1. Rather than buying commodities directly, an investor may purchase shares in a mutual fund that specializes in these investments. This alternative is especially attractive for the individual who does not have the expertise or time necessary to watch his investments on a day-to-day basis. Such attention is absolutely essential in the commodities area due to the rapid price movements and low margin positions. Commodity funds offer professional management and the constant attention demanded by this volatile market.

2. A "commodity pool" is an alternative to mutual funds, but has many of the same characteristics. For instance, in order to participate in a diversified portfolio of commodity futures with professional management, individuals will purchase units in the pool. Their money is combined and invested in a number of active commodities. In many cases the pool will be closed out when 50% of the original capital is lost. These are normally structured as limited partnerships requiring a minimum investment of $5,000 or more. In addition to a minimum investment, these pools typically require that investors have a minimum income and wealth position.

WHERE AND HOW DO I GET IT?

Investors may trade contracts on commodities through their brokerage firms in much the same way as they buy and sell securities. A separate margin account is required and settlement on this account will be made on a daily basis as described above.

An investor may also take part in a so-called "managed account" program with a particular commodities broker or trading firm. Under this arrangement, the commodities broker has the discretionary power to trade for the investor's account. An added characteristic of these managed accounts is that the broker may participate in the profits earned on the account in addition to any commissions that may be generated by the trading activity.

Investors may also invest in commodities through mutual funds that may be purchased through a broker or, in the case of some funds, directly from the fund itself. Minimum investments generally range from $1,000 up to $10,000. An advantage of these funds is that they enable individuals to participate in a portfolio of commodity contracts that provides a degree of diversification that the small investor may not be able to achieve otherwise.

WHAT FEES OR OTHER ACQUISITION COSTS ARE INVOLVED?

A commission or service charge is applied to a commodities trade in much the same fashion as the buying or selling of stocks and bonds.

HOW DO I SELECT THE BEST OF ITS TYPE?

1. Investors should concentrate their attention on a few commodities rather than spread their investment over a large number of different contracts. More time and effort will be needed to follow commodity positions than similar investments in stocks and bonds, and the average investor will generally be less knowledgeable about commodity markets.

2. Select markets that are active and that have a large "open interest" (i.e., the number of contracts in a commodity that have not been closed out, exercised, or allowed to expire). The level of open interest is reported daily in newspaper commodity pages. Conversely, beginning investors should avoid "thin" markets that are especially prone to volatile price swings because of the relatively low number of contracts and the small number of active traders. Some of the more active commodities are soybeans, wheat, cocoa, and copper.

3. Inexperienced traders should begin with a conservative position of one or two contracts that mature in a distant month. This will require a relatively small investment and give the investor time to study the market and get better acquainted with its characteristics before making greater commitments. Also, buying contracts in distant months will reduce the amount of trading and the amount of commissions charged.

4. It is generally a good idea to put in a "stop-loss order" 5% below the market price when buying a commodity, and 5% above the market for a short sale. This approach will limit the investor's losses while allowing for continued gains if the market moves in the anticipated direction.

5. Never put up additional margin to maintain a contract. If you are asked to do so it means that the market is moving against you and will likely continue to do so. It is better to liquidate your position and take a small loss rather than continue to increase your investment and risk a major loss of capital.

6. This is an area where an experienced broker can be invaluable. Investors should look for a firm with a strong background in commodities, and deal with a broker who is a specialist in the field. It is not likely that a broker whose area of expertise is stocks and bonds will also be knowledgeable in the area of commodities. Diversified investors may want to maintain a separate brokerage account for their commodities trading activity.

WHERE CAN I FIND OUT MORE ABOUT IT?

1. Daily price quotations on various commodities can be found in the Wall Street Journal (www.wsj.com) and other major financial newspapers.

2. Most of the major brokerage firms have departments that specialize in trading commodities. They can be a source of reports and charts on the various commodity contracts.

3. Serious traders may wish to subscribe to the monthly Technical Analysis of Stocks and Commodities Magazine published by Technical Analysis, Inc., 800-832-4642 (store.traders.com).

4. The Chicago Board of Trade (www.cbot.com) publishes a reference book entitled, Commodity Trading Manual. The Chicago Board of Trade web site has a wealth of information on both physical commodities and financial products, like Treasury bond futures contracts. It includes basic information on all contracts, as well as beginning and advanced commodity trading strategies.

QUESTIONS AND ANSWERS

Question--Why are the margins on commodity contracts so low in comparison with those on stocks and bonds?

Answer--The margin on a commodity contract is a security deposit to ensure performance on the contract. It is not a down payment on the commodity itself or a payment of equity as in the case of stocks and bonds. A similar concept applies in the field of real estate where a security deposit is typically paid to the seller of a house by the buyer to ensure that final payment will be made at the time of closing.

Question--Is commodities trading regulated?

Answer--Yes, the Commodity Futures Trading Commission (CFTC), an agency of the federal government, regulates the trading of all domestically traded commodities. The CFTC sets price fluctuation limits, prohibits excessive market positions, oversees the handling of investors' funds by brokers, and allows trading only on designated exchanges.

Question--Where can an investor obtain information on the commodities themselves?

Answer--A commodities investor must be concerned with a number of fundamentals and their relationship to each other. These include (1) the amount produced, (2) the surplus from prior years, (3) the amount that must be saved and is, therefore, not available for current use, and (4) the amount that is currently needed.

The United States Department of Agriculture (USDA) makes public announcements of most of this information. Until the public release, this information is a closely guarded secret.

Other factors that will directly or indirectly affect the price of various commodities are the weather, crop and animal blights and diseases, political influences, technological changes, and the expectations of farmers and other commodity producers.

CHAPTER ENDNOTES

(1.) The 15% rate applies to long-term capital gains realized on or after May 6, 2003 (under The Jobs and Growth Tax Relief and Reconciliation Act of 2003). The rate for long-term capital gains realized before May 6, 2003 was 20%.
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Title Annotation:Tools of Investment Planning
Publication:Tools & Techniques of Investment Planning, 2nd ed.
Date:Jan 1, 2006
Words:2968
Previous Article:Chapter 14 Financial futures.
Next Article:Chapter 16 Mutual funds.
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