Why Investing in Commodities (Part II)

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In the first part, I wrote about your responsibility as the client when investing your money in any financial market. I also mentioned that investing is the art of predicting the future, and what consideration should be taking regarding this aspect of the financial markets. In this second part, I will refer to the Risks involved in trading, particularly in the commodity market, and how to avoid some of the most common mistakes that investors make without even knowing. 3) Understand Risk Future contracts and options over futures are highly leverage instruments, so they are considered risky investments. However, this characteristic of the commodity market is not a reason to run away from the possibility of investing in it. Remember that leverage is a two ways sword: it can hurt you, but it also can provide you with percentage returns that you probably won’t find in other markets. In order to have a better chance of being successful in this market you have to understand the risks you are taking in each and every trade. You have the right to ask your broker about the risks involved in the trade he/she is offering you. Always remember that there are different types of risks that you might be taking without knowing. For example, you can be told that you should only buy options over futures because the risk is limited to the amount of money you invested plus commissions. This is absolutely true, but do you know that a high percentage of options expire worthless? This means that if you only make this type of trading you have a big chance of end up loosing all the money on your account. Another highly risky investment is to buy deep out of the money options (this example does not apply when selling deep out of the money options). These options can cost you for example only $200 each, so you might be advised to buy 5 contracts. This buying of deep out of the money options are the type of investments where the client is trying to make a fortune in one trade. These trades almost always do not work; the only thing you achieve when making those type of trades is increasing your risk and paying a lot of commissions to your broker. When trading futures contracts there are also many ways of increasing the risk. For example, you can decide to go short on Unleaded Gasoline the day before a hurricane hits the Gulf Coast. Maybe you are thinking or are told that the hurricane is going to change direction at the last minute according to weather reports, so the next day all the energy complex is going to collapse and you will make a fortune on your short position (again an example of an investor trying to make a killing on one trade). Another typical mistake that investors do and hence increase their risk is to send money to cover a margin call. If you have a margin call, first close the position because it means that you are in a loosing position. If after you close the position, you still owe money to your broker, then send the money; and if that trade was your broker advise and was not the first time that you had a margin call, then change broker. As you can see in these examples, risk is always part of the commodity market as it is of all investment markets. There is nothing you can do about the risk that belongs to the market, but respected it. However, you can have a better chance of making money, if you understand the risks associated with the trades you are advised to make. 4) How Much Money to Start In order to answer this question, first you have to decide whether you want to trade on your own or have someone giving you the trading recommendations. Commodity markets are different from the stock market; is not a good idea to trade on your own if you don’t have access to real time quotes, broadband Internet and the time to be in front of your computer most of the day. Remember, because of the leverage, mistakes are very expensive in this market. For small investors, the best thing to do is to open an account with a broker that you feel confident with and that will give you advise and manage your positions. There is all kind of minimum requirements regarding the amount of money that you need to open an account. I think that small investors that are getting started in this market should open with a minimum of $5,000 and maximum of $20,000. Less than $5,000 is not a good idea because it narrows you on your possibilities of diversifying your money in different markets and types of trade, which is another way of increasing your risk. I also don’t advise clients to open with more than $20,000 because remember that when you open your account, what you are basically doing on your first trades is seeing if the broker you are starting to work with has the ability and potential to make you money. As I mentioned before, if you loose money on your first 4 or 5 trades, chances are you will keep loosing money on that account. It might be cheaper to find some other place to work with. Conclusion Small investors do have an opportunity to make money in the commodity market. If you want to increase your chances of being successful in this market, you also have to do your part. It is not enough just to look for a broker, sign the paper forms and send the money. As the owner of the funds, you have the responsibility of understanding where your money is being invested and what are the risks involved in every trade. Finally, remember that you are not opening an account to get rich in the very short term. You are investing in the commodity market as a way of diversifying your investment portfolio, trying to achieve a better return overall. Jorge Malo is the President of TeoFutures, an Introducing Broker who specializes in working with investors who want to participate in the commodity market with a minimum of $5,000. TeoFutures trades Futures contracts and Options over Futures on a non-discretionary basis for our clients. Mr. Malo has more than 15 years experience in the financial markets in the US and abroad, and is a member of the National Futures Association. Please visit our Web page at http://www.teofutures.com to learn more about the commodity market and our company, and to subscribe to my Free Weekly Financial Newsletter with important market information and analysis.