Source: sxc.hu Photo: Baltar

Source: sxc.hu Photo: Baltar

With all the recent talk of economic stimulus, it is little surprise that talk of another kind is cropping up as well. With our economy likely to be flooded with cash in the coming months, many analysts (Peter Schiff comes to mind) are talking about the possibility of inflation. Inflation basically represents an erosion of your buying power as the value of the currency declines. In order to protect yourself against inflation, there are those who recommend that you invest in commodities.

What are commodities?

Commodities are tangible goods that can be traded. Unlike our currency, which has nothing besides promises and a perception of value to back it, commodities represent hard assets. These are things like precious and industrial metals, lumber, oil and gas, livestock and agricultural crops. Commodities are traded on an exchange, either for immediate, physical delivery (spot), or for future delivery (futures) in which the investor rarely receives physical delivery (contracts are settled prior to delivery). Most investing in commodities undertaken by individuals takes place on the futures market; for the most part, only producers and direct users of commodities actually make use of the spot market.

Commodities futures are designed to protect producers. An example is of how this works with farmers. A farmer may have a crop of soybeans that s/he plans to harvest. Before s/he plants it, he can sell it for cash at an agreed-upon price. The farmer may get a better price for it if s/he waits, but there is also a chance that prices plummet. By selling the future crop, the farmer is assured that expenses will at least be met (and maybe some profit received as well). The buyer then puts the contract with the farmer up on the futures market, where it can be “bought” and “sold.” If something happens and the price of the crop heads higher, the futures contract holder wins; the commodity is worth more than s/he paid for it. If something happens to drive prices lower, though, the contract holder loses out.

Right now, commodities that are expected to gain dramatically as the global economy improves include agriculture, uranium, iron, copper, and oil. These commodities, in general, gain fast in periods of economic expansion — especially in the early stages. These are items that are in demand by industrial societies as they gear up for a spike in economic activity. While gold bugs will tell you that precious metals are the way to go, it is worth noting that gold has only grown in purchasing power at the rate of 2.7% per year — hardly an inflation-buster. (But gold is still popular as a safe haven investment in times of economic uncertainty.)

Commodities trading and risk

Any sort of futures trading is risky. On top of that, commodity prices are volatile, changing as new political currents, economic data and natural events come to light. Another factor to consider is that with commodity futures, you are using leverage to control large positions. A commodity futures contract allows you to take a relatively small amount of capital of your own, and leverage it into huge positions in commodities by borrowing from your broker. The chance for profits is greater, but so is the risk of loss. If you do not have the risk tolerance (financial and emotional) for commodities trading, it is a good idea to stay away.

You can reduce your exposure to the risk of commodities by using exchange traded funds. There are ETFs that track commodity indexes, as well as ETFs that focus on a basket of commodities. Commodity mutual funds are also available (but watch out for load fees and other costs). While risk remains, using these types of investments is often less risky than becoming engaged on the commodity futures market. Plus, they can add some diversity to your portfolio. Commodities can make a desirable addition to your investment portfolio if you want to add a little more growth potential and can stomach the risk. However, it is important to be careful, as the volatility involved in the commodity futures market can lead to losses that are even large than the gains.

It should be noted that commodity trading in the futures market by non users is essentially speculation and carries with it great risks. Due to leverage, incorrect trades have the potential to wipe out an investor’s principal and then some. Extreme caution is warranted.