Traditionally, building an investment portfolio has involved holding two asset classes: stocks and bonds but these days more investors are looking to commodities to diversify their portfolio and give turbo-charged growth.
In today’s article we look at what is essentially commodities 101. We will cover some basic terms that are used in the world of commodity trading so that in the next article we can “hit the ground running” and start to learn about strategies for trading commodities.
The first and most obvious question to answer is what are commodities? and the answer is very simple – A commodity is any physical substance traded on the futures exchange. Some different types of commodities include Orange Juice, Oil, Gold and Unleaded Gasoline.
A more complex question to answer is how to trade commodities? Over the next 3 articles I will be showing you how to formulate some basic commodity trading strategies.
Before making your first few commodities trades it is essential to understand some basic terminology become familiar with a couple of basic rules:
- Establish and understand your risk profile.
- Be ready to detach emotion from your trading decisions.
What do I mean by establishing and understanding your risk profile? Simply put, you should decide how much risk you are willing to take and fully understand the risks involved in the different types of commodity trading strategies open to the retail investor. Commodity trading utilizes leverage and can be volatile. You should only invest risk capital and should be prepared to lose what you invest if the trade doesn’t pan out the way you expected it to. If this sounds too risky for you then maybe commodity trading is not for you.
If you are still reading and are not reeling at the chance of losing money then it’s time to talk about the second important rule. Emotion has no place in any commodity trading strategy. A successful commodity trader is able to detach themselves completely from their feelings and make logical, informed decisions about when to buy a commodity and more importantly when to sell.
Now that you have made it past the first few paragraphs and are still interested in trading commodities we will start to look at some basic terms that you will need to know before you can make your first commodity trades; call options and put options.
A call option is an option that gives the holder the right but not the obligation to buy the underlying commodity at a predetermined price on or before a set expiry date.
To understand what this means in more basic terms let’s use Pizza Hut as our example. Imagine that a pepperoni pizza is normally $10 but there is a special coupon that allows the holder to pay only $8 for the same pizza. In our analogy the coupon is a call option and the Pizza is the commodity. The coupon has a value of $2 because it allows the holder to buy a $10 pizza for only $8. Now let’s imagine that there is an expiry date on our coupon and if we have not used it by that date then it no longer has any value.
A put option is an option which gives the buyer the right but not the obligation to sell the underlying commodity at a predetermined price on or before a set expiry date.
In the real world let’s imagine a phone shop is doing a buy back program for Samsung Galaxy phones at $220 but to make use of the promotion you have to show the voucher before a certain date. Using this analogy the Galaxy phone is the commodity and the voucher is the put option. Now let’s imagine that another shop is selling a second-hand Galaxy phone at $170. You are able to sell the phone that you just bought for $170 at $220, a profit of $50. This is the value of the voucher.
In the next article, we will take a look at some basic commodities strategies. Until then it’s time to make sure you are familiar with the basics we have covered in this article and get ready to make some profits in the exciting world of commodity trading.