You can’t help but think about risk when you think about trading commodities. Whenever I tell people what I do for a living, I always get a similar response – Hmm, commodities…they’re risky aren’t they?
The aura of high risk in commodities is strangely what drives many investors into the commodity markets. Some people seek out a different path and commodities is certainly a path less traveled and less understood. Only a small portion of the population truly understands commodities and is willing to jump into this speculative arena.
But, is the risk of commodities misunderstood or avoided for good reasons?
The main reason why commodities are considered risky is that commodities are traded in futures contracts and they are highly leveraged. A commodity trader normally only has to put up 5 to 20 percent of the contract in futures margin value to control the commodity investment.
For example, the price of crude oil is trading around $82 a barrel. The crude oil futures contract is 1,000 barrels. The total amount of the futures contract is $82,000 and a trader would only have to put up about $5,100 to control $82,000 worth of crude oil. For every $1 that crude oil moves, a trader could potentially win or lose $1,000 per contract held.
Crude oil often moves more than $2 every trading day. How do you feel about entering a commodity trade with $5,100 in margin and realize that position can move for or against you by about 40 percent every day?
That kind of leverage in the hands of an undisciplined trader is the reason so many new commodity traders lose money. It is commonly discussed in the futures industry that anywhere from 80 to 95 percent of traders lose money in commodities. Most of these traders are also new to the markets and have accounts of less than $50,000.
Looking at the professionals in the business is a different story. Commodity trading advisors (CTA’s) have a much better track record with managed futures. The popular Barclay CTA Index has CTA’s making an average compound annual return of 11.56% from 1980 to 2009. There were only 3 losing years and the worst was –1.19%.
So, the statistics show that commodities can be very risky to the small trader who is not prepared for the leverage. On the other hand, market professionals have been able to show very consistent returns as they trade large pools of money and they are able to control the risk through diversification and thoroughly tested trading strategies. In the end, commodities can be very risky or they can be just another investment that often earns above average returns.
