Futures/Commodities Trading

For a long time I've been interested in commodity/futures trading. It's this bizarre world: trading contracts dealing with wheat, sugar, orange juice, oil, gold, frozen pork bellies.... And everything is crazy leveraged: You can control some amount of a commodity with just 1/20th of its value. E.g. You can put down a $5000 deposit (the margin) to buy 1 contract of gold, which is 100 ounces, which is worth around $94,000 at today's prices. You can make or lose thousands of dollars per day.

It used to be only the uber-rich would play in commodities, other than farmers who would buy futures to actually hedge against changes in the markets that would affect their income negatively. But in more recent history, new "mini" contracts have sprouted up that are 1/2 to 1/10 the size of the regular contracts, allowing smaller players to get into the market. It is also easier to setup futures trading accounts nowadays. However, I've never run across anyone talking about trading futures, other than one older family friend years ago. You just don't hear Joe in the office talking about his soybean contracts doing well.

The commodity markets are hard to learn about and understand. There is not much good information out there and I think it takes a lot of experience to really get a feel for things. Even though there are trillions of dollars traded in futures each year, there aren't many little guys participating. It is risky. I remember reading stats on how most amateur futures traders end of losing most of their money, mainly due to not understanding and managing the risk involved.

Anyway, it is really interesting stuff and I'm going to try to get my feet wet. I was surprised that there aren't more online brokerages that offer futures trading accounts. In fact, I couldn't find one true Canadian one that looked trustworthy and mature. After much research, I finally settled on OptionsXpress.ca. They're still an American company which happens to have a small Canadian arm to allow us Canadians to get involved.

OptionsXpress really impressed me. They have an amazing website with tons of information on it. It makes you feel very welcome and comfortable. All of their information is easy to follow and understand, and they are completely open about everything. You really seem to know a lot about them after reading through the site (compared to some sites that don't have much info and thus seem more shady). They seem trustworthy, their trading platform seems solid and easy to use, they have tons of help and examples for every type of trading action available, all sorts of common questions are answered in their FAQs, and they have a Live Help feature -- it all really gives you peace of mind. I actually used their "Live Help" feature and chatted online with a person, who was very helpful and answered all my questions. I've started the process of setting up an account, and everything has been so smooth so far. They give you FedEx shipping labels for free overnight shipping of your application, and you get automated emails for each stage in the process (e.g. "We just received your application and are now processing it). I'm looking forward to using them. However, who knows, I may not even get approved -- it's a two step process: first creating a regular equity/options account, and then applying for futures trading.

It seems the most popular online broker is interactivebrokers.ca/.com. They have crazy low fees and apparently have the most powerful trading platform, but I've heard it's very complex to use because of this. They seem geared more towards experts than to first time traders, so I didn't feel comfortable going with them. All the other brokers I looked into just didn't seem as organized, informative, and trustworthy as OptionsXpress.

The first thing I want to trade, if I can get an account setup soon, is probably the most volatile commodity out there: Natural Gas. More in my next post...

Shift Investments to Oil? Part 1

I've been thinking a lot about what to invest into next, from the point of view of "where can I make the greatest amount of money (both short-term and long-term), with minimal risk." And I'm coming to the conclusion that the place to be is: Oil.

Commodities vs Stocks:

From the risk perpective, I've been looking at ETFs comprised soley of commodities -- that is, the commodities themselves (e.g. oil, gold, corn, wheat) that trade on the futures exchange, not stocks of companies that are involved with such commodities (the latter of which most commodity-related ETFs actually hold, e.g. DIG). The risk of a further drop in the stock market is quite possible, and it's even more possible that after a brief rally, the recession/depression in the U.S. keeps the markets from gaining that much for the next few years. We've already seen gold stocks lose 50% of their value while the price of gold has gone up, so in a volatile market in the middle of a recession, stocks are a risky place to be. The prevailing consensus is that most commodities can only go up in the long term, especially energy and agricultural related commodities due to the double-whammy of increased consumption (due to world population increases and the rapid development in countries like China and India) and declining production (running out of resources, getting harder and more expensive to grow or extract resources).

Now, unless you're buying actual futures contracts, which often have a leverage of 10:1, it used to be that stocks related to the commodities would go up by a much larger percentage than the percentage increase in the commodities themselves. So while I'm interested in commodities, I still want something that will increase a lot when the commodity goes up. We'll get to this later...

Which Commodity?

While Sprott and others believe gold will go to $2000, there seems to be some risk that that may not happen, or it may take a while. I've noticed the guys at Sprott seem to talk more about energy and oil than gold. I'll be pointing out some quotes from the recent Sprott Webcast that talk about the Oil situation a little later in this post. There seems to be less downside risk in Oil to me, but maybe I just haven't read enough views about how bad the current and upcoming (short-term) decrease in demand could affect things and how low oil could go. Then there are other commodities, such as agricultural ones, which don't get much attention and which I honestly haven't looked into that much. World population and increased standard of living in China in India are going to mean we'll need more and more food (whether to feed the people or to feed the animals that the people will eat!). It's hard to say which commodity has the most potential and least risk, but lets see what's happened with some of the commodity ETNs the last little while...

Commodity ETN potential performance:

The only 2x leveraged pure commodity ETFs I know of are the ones from from Deutsche Bank (who is known for their PowerShares series of ETFs). Their pure commodity plays are actually ETNs (Exchange-Traded Notes), which don't seem much different from ETFs to me. Their list of commodity ETNs can be found here. They haven't been around that long, but most began trading just before the peaks in commodities that occurred around March 2008 or end of June 2008. Let's look at the difference in price now from their peak, in order to see the potential gains we would make if they went back to their peak price...

Gold 2x ETN: DGP (comprised of Gold futures):
- Current price: $12-14 Peak Price: $28 Difference: 2x

Agriculture 2x ETN: DAG (comprised of corn, wheat, soybeans, and sugar futures)
- Current price: $8-11 Peak Price: $29 Difference: 3-4x

Base Metals 2x ETN: BDD (comprised of Aluminum, copper, and zinc futures)
- Current price: $7-8 Peak Price: $28 Difference: 4x

Oil 2x ETN: DXO (comprised of Oil futures)
- Current price: $4-6 Peak Price: $29 Difference: 5-7x

Commodity 2x ETN: DYY (just a mix of everything, specifically: wheat, corn, oil, heating oil, gold, and aluminum)
- Current price: $8-10 Peak Price: $35 Difference: 4x

So any of these look pretty good -- a chance to make 2 to 7 times your investment if the commodities go back to their peaks. Now you could argue that that scenario is unlikely, as the commodity boom was fueled by a lot of speculative traders. However, Sprott and others are arguing that the commodity boom will continue, especially with oil and gold having nowhere to go but up.

Looking at the above numbers, we can see that oil has had the greatest drop, and maybe the greatest potential to reach it's previous highs again. Can you imagine making 500% (6x) your investment in a few years if oil hits the $140's again? What is the risk? Could Oil go back down to $30 or $20 again?

Anyway, that's all for this post, which just touched on the potential for gains in the commodities -- specifically oil. In the next post, I'll mainly talk about what Eric Sprott talked about in the latest webcast, and then look in more detail at investing in DXO.