Commodities: No Higher Risk on the Market
You may have seen one of the recent ads on the radio or television advertising, "You can make a fortune trading commodities/futures!" These ads are famous more for what they dont tell you than for what they do tell you.
Commodities trading is really futures trading on a given commodity, such as gold, sugar, wheat, cotton, or cattle. Commodities/futures are not considered securities and therefore are not regulated by regulatory bodies such as the NASD or the SEC. Rather, a separate self-regulatory body called the National Futures Association (the NFA) regulates commodities.
Commodities trading is one of the oldest types of contracts there is, dating back to the time when silk traders would travel to the Orient, but due to the long trip by sail, a merchant would forward contract (sell) his silk, thus assuring himself a profit when he returned months later with the goods. Today, this forward hedging of commodities is still a very important aspect of commodities and futures trading. One of the more recent uses is portfolio managers employing investment contracts (S&P futures) to hedge portfolios. But the ads and the brokers arent soliciting you for hedging purposes; they are enticing you to speculate.
And speculate is the proper word, because in commodities trading, you can make and lose fortunes overnight. Commodities is one of the few types of investments where you can lose more money than you invested (naked stock options is another type). Recently, there was a Dean Witter arbitration where a client opened up a commodities account and said he was willing to trade and lose a maximum of $50,000. The commodities form asked what his trading limit was and in numerous places, he stated that his limit was $50,000. Yet, in a matter of months, he lost $83,000. At the arbitration, the broker, the manager and the compliance officer all agreed that there is no trading limit for commodities, even though the trading limit is stated on the forms. You cannot control or limit the losses in commodities.
A number of factors make commodities more risky than other investments. One is the fact that its an investment that can fluctuate in value depending on whether or not it rains on the other side of the country. If you think its hard predicting the stock market, try predicting the weather.
Another reason commodities are so risky is that the leverage (similar to margin) is much greater than it is with stocks. You can control as much as $100,000 in commodities with only a few thousand dollars of investment. Therefore, a small price change in the underlying commodity can exaggerate either the profit or loss on the investment.
Commodities have limit moves. Thats the maximum daily amount a commodity can move in price within a given day. On its face, this might sound conservative; stocks dont have limits and can move up or down limitlessly. One of the reasons for a limit on commodities is because commodities are heavily margined. It is possible to lose great sums in a matter of days despite the daily limit move, because if the commodity moves the limit, theres an excellent chance that you cant make a trade to cut your losses. If the commodity goes "lock limit" for 3 days or more, you may see yourself losing vast sums with no way to get out.
If you open an commodities/futures trading account, you will need to do it with someone who is licensed in this area. A typical stockbroker cannot trade commodities for you without an NASD Series 3 license. In a commodities account, anticipate roughly three times the number of documents required for you to review and sign, contrasted with a regular brokerage account. There will be a host of warnings proclaiming that commodities trading is very risky and that you can lose all of your investment and then some. These disclosures make it tougher to sue, even if you invested and lost your childs college education and even if the broker outright lied to you.
If you have a hunch and are determined to trade commodities, one way you can do it and potentially limit your losses, is to trade options on commodities. As in stock options, the maximum amount you can lose is the amount of options you purchase. But even with this strategy, keep two things in mind. One, make sure that you only purchase options and dont sell any, because selling a naked option is no less risky than owning the underlying futures contract. Second, if you think its hard to make money trading futures, its even harder trading commodity options; not only do you need to guess right, but timing is more crucial than with futures.
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Tracy Pride Stoneman is an attorney specializing in investment related complaints. Preparation of this article was assisted by Douglas J. Schulz, a registered investment advisor and former stockbroker in Colorado Springs.