Are Commodities Risky?

Despite their inherent durability, there are different risks involved with investing in commodities, especially when one considers the different aspects of the initial investment, the type of loan or margin at which the commodity is purchased, and in some cases, the nature of the commodity itself.

Although market forces do not impact commodities in the same way they impact stocks, they do play a role. If an investor has allocated a significant portion of his portfolio into eggs, for example, and a biological blight renders an entire month’s supply of eggs unusable on one continent, the difference between the expected performance of the commodity and the dismal reality will cause that investor to lose substantial amounts of money, depending on the types of contracts that investor has secured.

However, this is not an automatic loss for the investor. Consider the following scenario. If the biological egg blight occurred in Europe, but the investor had invested in unusually high demand futures in the United States, the investor would actually reap enormous profits from his investment when Europe’s lack of supply forced the continent to import eggs from other countries. Europe’s significant demand would bolster egg prices in the United States, thereby dramatically increasing egg performance over standard industry expectations.

Of course, this scenario requires unusual acuity and luck on the part of the investor. Consider the reverse scenario, which is just as likely. This same investor has invested in high egg supply futures in Europe. When the blight occurs, the supply drops astronomically. Should the investor have purchased futures, as opposed to options on this commodity, he will be required to sell his futures at a pre-appointed date for an agreed value. When he attempts to sell his high European egg supply futures in a climate of enormous demand, he will lose a tremendous amount of money because the market simply does not match the anticipated futures.

In each case, there is really no way for the investor to know whether eggs will experience high supply or high demand in Europe when he buys the initial future or option contract. In this way, commodities can be a risky investment, because they are prone to natural disasters and other events that no ordinary human can predict.

However, there are always ways to mitigate risk. In each version of this scenario, the investor chose futures which required the market to behave in unusual ways. It should be noted that investors can choose to invest in commodities with a high volatility ranking to increase their chance of windfalls, but that this strategy can also backfire and result in tremendous losses. Many commodities have low volatility rankings, and will therefore perform in a fairly predictable way.

Additionally, there are so many ways to invest in commodities—including a yield curve approach, where an investor buys the same type of commodity with different future maturity dates—that an experienced investor will probably be able to balance any high volatility commodities with steadier performers.

An investor must also consider the benefits of the specific financial tools he uses to acquire the commodities, such as “futures” versus “options.” Each poses its own risks, from the amount of the initial investment to the agreed sell date. Depending on what financial institution the future or option is purchased from, an investor may be subject to variable margin fees. While each of these topics will be explored in-depth in subsequent sections of this guide, an investor should know this: while risk is certainly a factor in investing in commodities, the nature of the investor and the amount of information he is willing to gather will largely determine how successful his investments are. In other words, commodities can be a wonderful investment, but a certain degree of risk is always part of every transaction. Nothing, unfortunately, is ever fully guaranteed.

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