The Commodities Market

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The Commodities Market: Here’s How to Make Money Trading Commodities

by Lee Lowell, Commodities Specialist, Mt. Vernon Research
Wednesday, August 15, 2007: Issue #701

Editor’s Note: Lee Lowell is one of the smartest commodity investors I know. For six years, he worked on the floor of the New York Mercantile Exchange as a market maker, and for the last 11, he’s been making a living trading his own money in commodities. He’s exceptionally good at it, too
More than 80% of the trades in his commodity advisory service have been profitable.

I talked to Lee this morning, and he’s looking at three possible trades right now. So as stocks continue to ricochet down Wall Street, here’s a way to make some money in commodities

A. Williams
Managing Editor, Investment U

I’ve been an active commodities trader for 16 years, both on the floor and off. And one of the reasons I like this market so much is that there are only 15 to 20 commodities that are truly worth trading.

When the number is that small, you really get to know the market’s behavior and seasonal tendencies. This allows you to become intimately familiar with each commodity, and that makes trading them much more profitable over time.

I’m always scanning these 15 to 20 commodities to see if any new trading opportunities exist. And at the moment, there are three I’m close to pulling the trigger on. But first, let’s look at how the commodities market works, and the best way individual investors can play it.

The Commodities Market is Pure Supply & Demand

The commodity markets tend to move in more predictable and smoother patterns over the long run, compared to stocks. That’s because they truly end up making their moves based on supply and demand

There are no firms and CEOs running the commodity markets. There are no quarterly earnings reports. And the Fed isn’t trying to intervene.

Many physical commodities are food-based in nature and tend to move according to growing patterns, seasonal tendencies and weather. We’re talking about corn, wheat, soybeans, coffee, sugar, cocoa, orange juice, crude oil, natural gas, etc. Prices are based on how well the crops are growing and how much supply of the product is currently in storage.

Although there are some government reports to contend with, they typically only give us a clue as to how the crop is progressing in the growing cycle. Even though you may read about a hedge fund or two trying to control a certain futures contract, the commodities market is so large and so deep, that the hedge fund may only have a very short-term effect.

With that said, if you’ve never traded commodities before, you may be wondering how you can get involved. It’s actually pretty easy

How To Buy and Sell Commodities

Commodity trading is actually just as easy as stock trading. The best way to get involved is through futures contracts and futures options contracts. Purchasing and selling these is the same as trading stocks or stock options.

Other than buying orange juice or coffee at the local grocery store, speculating on the future movement of physical commodities can be done by buying and selling futures and futures options contracts that trade on one of the designated commodities exchanges around the U.S.

The most notable futures exchanges are the New York Mercantile Exchange (NYMEX), the Chicago Board Of Trade (CBOT), the Chicago Mercantile Exchange (CME) and the New York Board Of Trade (NYBOT).

You can trade both futures contracts and futures options contracts at these exchanges. The only thing you would need to do is open a commodity trading account with a registered commodity broker. (See today’s Crib Sheet for a list.) This is no different than opening a stock trading account.

Once your account is open, you can trade commodities the same way that you trade stocks. Do your research, look at the charts, check the fundamentals, and then enter the trade. For me, the only way to play commodities is through the use of options contracts, for a couple of reasons

Options keep your risk limited at all times, but the gains can be unlimited. This lets you sleep soundly at night, as you never have to worry about unlimited risk, like the risk associated with short selling stock.
With options, you don’t need to be correct on your directional assessment of the market to have a profitable trade. It’s true. You can be totally wrong on the direction, but your options can still produce a profit. (Selling “option credit spreads” is the strategy that can do this.)

Now let’s take a look at three potential plays I’m keeping my eye on right now

Three Ways to Play the Current Commodities Market

1. Natural Gas

The natural gas market has taken a big beating to the downside over the last two months. My sources in the option pits tell me there might have been another troubled hedge fund that was liquidating futures contracts that led to the big decline.

The other reason is that the large amount of natural gas supplies in storage has been weighing on the market. But, as we have learned over the last few summers, we’re about to hit the major portion of hurricane season, and not too many people want to get caught short this market when hurricanes do decide to come our way.

The chart below shows that natural gas futures have most likely made a bottom and will probably trend higher from here, or at least not retrace much lower.

2. Coffee

Here’s a chart of the December 2007 coffee futures:

Although a major portion of coffee is grown in South America and its winter season is winding down, we’re seeing a push here to the upside that may keep going. If it can stay above the resistance line that I’ve drawn for the next few days, it might be ripe for a bullish trade.

3. Orange Juice

Lastly, we have the orange juice market

Although orange juice is not known for its high volume or huge following, we do know that during hurricane season we can see major moves to the upside.

This is a highly speculative play, but if Florida gets whacked with a few hurricanes over the next two months, we could see the orange juice futures move to all-time new high levels. Considering the massive drop the orange juice market has endured since the spring, taking a limited-risk bullish option position could be the smart play.

Good investing,

Lee

Editor’s Note: To learn more about Lee’s commodity advisory service, and to get his recommended trades delivered to your inbox, here’s how it works.

Today’s Investment U Crib Sheet

Here are three commodities brokers you can use to get started. All of them know Lee, and are familiar with his strategies. We receive no compensation from these groups. This list is for your benefit only: