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Investing in Commodities: What, Where, Why

If you really want to know what drives the global market of commerce, you must obtain an innate understanding of commodities and the facts behind investing in commodities. Commodities and their prices have long dictated the laws of supply and demand, determining imports and exports and attracting innovators who dare to make things more efficient or valuable.

In simplified terms, commodity prices move and the stock market reacts to those movements. Yet it’s interesting, most books about investing don’t broach the topic of commodities. So how are these investors able to be successful?

Well in the same sense that you don’t have to be a mechanic to be a great car dealer, those who are good at picking stocks don’t necessarily have to know how commodities prices are affecting long term prospects.

But it couldn’t hurt to learn. In fact, it can very well give you an advantage in a world where quarterly earnings are dissected excessively.

Here’s the definitive guide to investing in commodities: its various methods, the background and applications in the real world, and how to help it benefit you.

investing in commodities

The commodity market was created out of a basic need for stability. You see, a long time ago farmers and other merchants were extremely dependent on the price of their goods and services. This dependence was not a good thing for everyone involved.

Just one bad year could completely wipe a farmer out. Consider a year where crops weren’t very plentiful. A lower supply of corn, let’s say, would drive the price of corn higher. This would make the farmer very rich, assuming he had plenty of corn to sell.

But consider the reverse situation. Say that there was a year where harvests were bountiful all across the world, so much so that there was too much corn to sell. This oversupply would’ve driven the price of corn lower, making it harder for the farmer to turn a profit on his labors.

A farmer can’t survive in an environment such as this. He has annual expenses that don’t care if he had a great harvest or not. The farmer needs to constantly buy or repair equipment, buy inventories and seeds, and pay for his own rent as well as feed his family.

And what if he was the only game in town? Now he’d have a whole city of people who are depending on him to stay in business, or else the whole economy could collapse.

It was these unfavorable conditions that led to the creation of the commodity market. What the market did was allow anyone to buy or sell contracts on commodities like corn. This was fantastic news for the farmer. He could now “hedge” his bets, by buying or selling contracts that would bring him profit if the price of corn fluctuated.

The way to buy hedges was through an instrument called futures. Futures trade on the current price of a commodity, and fluctuate daily like the stock market. The flashing quote screens and charts you see in the movies represent commodities and the futures market.

Now the farmer could bring in enough profit no matter what happens to the price of corn. By buying the right number of contracts, his bottom line would be covered and allow him to stay in business no matter what happens in the market.

Author’s note: You can also use options for similar hedging purposes but that is for a different topic and blog post

Companies today do the same thing with derivatives. Business owners are able to use the commodity market to hedge themselves just like the farmer used to. Commodity investing, trading, speculating, and hedging draws more attention now than ever before.

Investing in Commodities: Application

Now that we know the basics of commodities, we need to learn how to apply them. After all, this information is of no use if it doesn’t make you money.

There are several major commodities that drive the world economy. You can find their charts by their ticker symbol. Here’s what they are, with their tickers:

$CRB-Thomson Reuters/Jefferies CRB Index (All Commodities)
$GKX- Agricultural
$GJX- Energy
$GYX- Industrial Metals
$GVX- Livestock
$GPX- Precious Metals

Important Financial Tickers:
$UST10Y- 10-Year US Treasury Yield
$UST- 10-Year US Treasury Note

Now, each of these major categories has individual commodities that also create a substantial effect on the overall stock market. For example:

$WTIC – Light Crude Oil (Energy)
$BRENT – Brent Crude Oil (Energy)
$COPPER – Copper (Industrial Metals)
$GOLD – Gold (Precious Metals)

We’ve seen how the falling price of crude oil from Nov. – Dec. 2014 has had an effect on stocks, particularly those in the energy industry. As the price crashed from around to $100 to the $60s, oil producers and suppliers have seen their stocks been absolutely crushed.

It’s only a matter of time before their earnings follow suit, which should lower stock prices even further.

These kinds of commodity price movements happen every single day and in every economic environment. An investor who is even slightly aware of these price movements can have a significant advantage over the average investor, who is dependent on the media to inform them.

commodity investing

I’ve recently found a nice tool to check commodity prices, with the convenient option to overlay multiple charts into one screen. You’d be surprised at how hard it was to find such a tool without having to spend a significant sum of money.

Being able to see all the charts at once will let us quickly compare and monitor any developing price movements before the general public is aware of them. From there, you can use this information to profit however you like. There’s more than one way to skin a cat.

Here’s the website I use for this purpose: Stock Charts. I’ve given you the same tickers I look at above, which you can easily change in the Symbols box. These are updated with only a 20 minute delay, and will give you the “pulse” of the markets.

There’s also an easy way to quickly read these charts. Traders who are familiar with moving averages and momentum will recognize the following terminology. This is by no means a predictive measure to work 100% of the time. Momentum doesn’t tell you what’s going to happen. Nothing will.

However, momentum can be useful to explain price movements such as the ones we will see on these commodity charts. I’d recommend using it to confirm an existing commodity investing hypothesis, rather than to create an original idea.

How to Read the Commodity Charts

The blue line on the chart is the short term moving average, in this case a 50-day. All that means is the average of the previous 50 days. The red line is our long term moving average, set here at 200 days.

You look for 2 things when it comes to moving averages. If the ticker price (indicated by the white and red moving boxes) is below both moving averages, this is a BEAR-ish sign. If the price is above both moving averages, this is BULL-ish.

Beginners tip: Bearish means negative, bullish means positive

Now when the moving averages “crossover” from one side of the price to the other, this is called a signal and marks the beginning of a new uptrend or downtrend. Momentum traders or trend followers tend to use these signals to enter or exit their positions.

The second thing you’ll want to look for is a crossover between the short and long term moving average. When you see the short term moving average crossover the top of the long term, this is a bullish signal. It’s easy to remember because you can think of the short term as driving more current price movements, and seeing it break through a longer term trend is positive.

Of course, when the short term moving average does the opposite and makes a crossover below the long term line, this is a bearish signal. The crossovers and positions of the moving averages can help you make sense of the charts as you check them periodically. Understanding the psychology behind what makes a chart bearish or bullish explains why stocks react the way that they do.

Now you understand what investing in commodities is all about and where you can collect quick information about it. I want to end this guide by showing you why this is all important. Let’s look at how to profit from commodity movements… what’s possible and how I use it.

You can very well take the information that I’ve given you, and use it as a springboard into commodity and futures trading with momentum or trend following strategies. You could even move up into the Forex market, where more trading is done than anywhere. If that speaks to you, then by all means follow your passion and run with it.

There’s plenty of people out there that have made millions trading this stuff and continue to help others make millions trading it as well. I won’t deny the obvious facts that it’s possible and continues to be done.

I’ll admit firsthand that while I study aspects of this trading, it isn’t my cup of tea for various reasons. But I do use elements of it to increase my own success in my own strategy.

That being said, all I ask is that you read the next bit with an open mind and an eager attitude. No matter what strategy you use to make money in the market, it helps to understand the psychology behind what makes a competitor also successful.

commodities

Now consider the situation where you’ve correctly recognized an uptrend or downtrend in a commodity. Let’s say you saw an early uptrend in $WTIC and made a significant investment in an oil producer who profits greatly from higher oil prices.

As a result, the oil industry gained 75% and you saw a nice return on your investment. Compare the possibilities of profit if there were two major players in the industry, one called Gary’s Growth Oil and the other Victor’s Value Oil.

Now let’s say that both companies made $2 billion in profit last year but the prices of these stocks were different. Let’s say Victor’s Value Oil was priced at a market cap of $20 billion while Gary’s Growth Oil was priced at $80 billion.

With a 75% increase in oil industry earnings, both companies would see annual profits grow to $3.5 billion. At first glance, it may seem that both stocks will grow at the same pace.

But look at it this way. Instead of looking at these companies as stocks, look at it as if you were a business owner. If you had $80 billion, you could buy Gary’s Growth Oil once, or you could buy 4 of Victor’s Value Oil. Compare the earnings available to you in each scenario. You could have $2 billion, or $8 billion if you bought 4 of Victor’s Value Oil.

So when you are buying these stocks, the logic remains the same. Stockholders are just part business owners in reality anyways. If you could buy 4 times as many shares of Victor’s Value Oil for the same price of Gary’s Growth Oil, you’ll get 4 times more ROI.

Let’s say you put $10,000 into each company. With Victor’s Value Oil, you’d get 4 times more shares than Gary’s Growth because it is ¼ less expensive in price. So with the increase in oil prices, you’d get ($3.5 billion x 4) = $14 billion in annual profit. Contrast that to just 1 share of Gary’s Growth Oil. That investment would only contain $3.5 billion in profit after the increase.

That’s a difference of a 17.5% return of investment on your capital versus a 4.4% return of investment.

The reason for this is the difference in the price paid for the stock. While an investor may accurately predict the right trend in a commodity, the profit won’t be as substantial if the investor pays too much for that stock.

This underlies the importance of what’s called value investing. This strategy concentrates on minimizing the price paid for a security in order to maximize the return.

By looking at investments in this way, the investor is essentially looking at investing as part ownership of a business instead of just how much money can be made. What makes this philosophy work is the power of the 8th wonder of the world, compounding interest.

Investing in Commodities w/ Compound Interest

When you own a business over a long time period, it rewards you by returning cash over time. In the stock market, this is called a dividend. Long term investing consistently beats out short term speculating because the collection of dividends over the long run turns into large sums.

While you can’t always control where any stock price may go at any time, you can control which investments you buy and what price you buy them at. If you consistently buy lower priced stocks (also called undervalued stocks), you maximize your returns as earnings increase and you collect dividends along the way.

If you’ve picked great businesses, both dividends and earnings continue to increase until your returns start to multiply over. Exponential growth… that’s the magic of compounding interest.

The parable of the tortoise and the hare doesn’t just apply to general life but to wealth accumulation as well. A portfolio of undervalued, high performers beats out overpriced and overvalued stocks 9 times out of 10. It’s why the famous quote is “buy low, sell high.”

The way that I invest in the market is that I look for the undervalued stocks that are likely to benefit from the commodities trend I have spotted. In other words, I look for good deals first, and then pinpoint the ones in a favorable trend to increase my chances of success.

So far, I’ve done very well for myself and have outperformed the market. But none of it would’ve been possible if I didn’t first learn about value investing.

A great start to the world of value investing would be another free guide I’ve written called the 7 Steps to Understanding the Stock Market. You can read about it here on the blog, and it explains each important principle with examples that are easy to follow.

Either way, you can use commodity investing to your advantage. Results happen but you have to do the work of educating yourself first.

I really believe you can do anything you put your mind to. So get to work.

**All Rights Reserved. Investing for Beginners 2015**
**Investing in Commodities: What, Where, Why (Guide)**