True Or False: Small-Cap Stocks Are Riskier Than Corporate Bonds. A Primer on Commodity Trading

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A Primer on Commodity Trading

Although most investors are only familiar with trading stocks such as stocks or mutual funds or investing in debt such as bonds, commodity trading is generally overlooked despite the fact that it has many advantages over other types of investment instruments. Let’s start by defining what a “goods” is. Goods can be of different forms. The most commonly traded commodities include lean hogs, cattle, oats, wheat, metals and even currency.

One of the advantages of commodity trading is the ability to make large profits in a fairly short period of time. However, most consider commodity trading to be extremely risky as most investors tend to lose money. However, by doing your due diligence and determining whether the commodity you are interested in is undervalued or overvalued, say if you want to go long or short, respectively, you can minimize the risk associated with trading commodities. It can also help to have an experienced commodity trader to help you.

When you trade commodity futures, you don’t actually buy or own anything, unlike other types of investments like stocks or bonds. You are simply speculating about where the price of this commodity will move. If, after research, you believe the price of coffee is going to rise, you would buy futures contracts or go long. On the other hand, if you had the impression that the price of sugar was going to go down, you would sell the futures contracts or go short.

As mentioned earlier, one can also purchase currency or market index futures in addition to buying or selling futures for commodities such as cattle and hogs. One of the advantages of trading market index futures is that you don’t have to invest a lot of money, unlike having to invest a significant amount of capital if you want to buy individual stocks. To illustrate: A $10,000 Nasdaq futures contract is equivalent to roughly $200,000 in shares. Let’s assume that you expect the market to rise quickly, you can potentially buy many of the stocks that make up the Nasdaq stock index (herd mentality), or you can buy a Nasdaq futures contract. Suppose you invested $200,000 in Nasdaq stocks, and if the index went up, you would have made a profit of, say, $25,000. However, if you instead purchased a $10,000 futures contract at the same time instead of investing $200,000, you would have earned the same $25,000 with a much smaller capital investment.

The downside to commodity trading is that it is usually done on margin to increase your investment, so a small drop in price could potentially cost you your entire investment. It is for this reason that it is important to do your due diligence and decide for yourself whether a given futures contract is a wise investment. While commodity trading can be fun, if not without risk, it offers investors another way to diversify their investment portfolios.

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