Currency and commodity trading is pretty much just what it sounds like. Currency trading occurs on the foreign exchange (forex). Although the forex is the largest financial market in the world, many fewer people have heard of it than, say, the New York Stock Exchange. Forex is also one of the least structured markets, which gives the trades made on it a kind of fluidity not found in other exchanges.
Commodity trading refers to the trading of agricultural products, something that has gone on around the world throughout history. It can have a tremendous impact on our daily lives. To take the most obvious example, changes in the price of oil impact you daily at the gas pump.
In this article, we’ll look at both of these forms of investing and how to make money from them.
TRADING CURRENCIES AND DERIVATIVES
Betting on Money
The idea that trading money can earn you money seems counterintuitive, but there’s a lot of money to be made in currency trading. Lots of people engage in this trade without even realizing it, as a matter of fact. Every time you visit another country and swap your dollars for the local coin, you’re involved in currency trading. In investing terms, currency trading is known as foreign exchange, or forex (FX). And, believe it or not, the forex market currently sees more than $5 trillion worth of trading every day. The bulk of trading involves the currency of eight major players, those with the most robust and sophisticated financial markets:
- United States (U.S. dollar, also called the greenback)
- United Kingdom (pound, also called Sterling)
- Japan (yen)
- Europe (euro)
- Canada (Canadian dollar, also known as the Loonie)
- Switzerland (Swiss franc, also called the Swissie)
- Australia (Australian dollar, sometimes called the Aussie)
- New Zealand (New Zealand dollar, nicknamed the Kiwi)
Of course, other currencies trade as well. But those listed are the most liquid and the easiest to trade profitably. The most important thing to remember is that currencies have relative value. For example, trading U.S. dollars for the Japanese yen will get you a very different result than trading U.S. dollars for euros. That’s because the currency pair you’re trading is based on each currency’s worth in relation to the other.
Currency Trading Is Different
Many of the investments we’ve discussed until now trade on formal exchanges. Not so with currency trading. Unlike virtually all stocks, ETFs, and options, currencies don’t trade in a regulated forum. There’s no central governing body (like the SEC). There’s no official body to guarantee or verify trades. This often seems crazy to novice forex investors, but the system (or, rather, non-system) works. Because it’s a free market system, the forex market is regulating, thanks to competition and cooperation among traders.
However, if you’re planning on testing the waters of currency trading in the United States, make sure you use an FX dealer that’s registered with the National Futures Association, as those dealers agree to engage in binding arbitration in the case of a dispute. Another notable forex difference: you can trade currencies twenty-four hours a day during the week. From 5:00 P.M. on Sunday to 4:00 P.M. on Friday, trading is continuous.
Rates Drive Return
If there’s one golden rule in the currencies markets, it’s that rates drive return. This concept is simpler than it seems. When you buy and sell currencies, they always trade with an interest rate attached: buyers earn interest; sellers pay interest. That seems like the opposite of what you’d expect, but it’s how the system works. From a procedural point of view, you are first selling one currency, then using the proceeds to buy another (though the transactions happen simultaneously).
When you sell a currency, you have to pay interest on it (sort of like a bond issuer pays interest); when you buy a currency, you earn interest along with it. Each currency has a unique interest rate attached to it, computed in basis points. Your net return is the difference, in basis points, between the currency you’re selling and the currency you’re buying. So if you were selling a currency with a rate of 400 basis points and buying a currency at 600 basis points, your net return would be 200 basis points (or 2 percent).
Derivatives are investments that derive their value from something else. On their own, they really aren’t worth anything. Their value comes from an underlying asset and changes in its value. For that reason, every derivative is the same thing as a bet. Derivative traders are gambling, usually on minute movements affecting the assets that lie beneath them.
Every derivative is a contract agreement between two parties. The most common derivative contracts are options, futures, swaps, and forward contracts. And these contracts aren’t written only on other investment securities, although that’s the norm. Derivative contracts can be written on things like weather data (will it rain in Florida in August?), holiday retail sales, or interest rates. But most derivatives are written on investment-related items: stocks, bonds, currencies, commodities, and even on market indexes.
COMMODITIES AND PRECIOUS METALS
Going for the Gold
When investors want to go straight to the source, they can invest in commodities or precious metals. These raw materials feed the production supply for every industry in the world, from basic needs like food to high-tech needs like virtual- reality games. While these goods are plentiful and replaceable, their prices may re- main low. Scarcity, though, drives prices higher. Even fear of scarcity (like we’ve seen with oil) can drive prices up. Savvy investors look at the growing resource demands of the world and put their money into those commodities that they expect the world to consume at the greatest rates.
This market has come leaps and bounds from where it started, while hardly changing at all. Hundreds of years ago, farmers would drag their corn and wheat to the markets, selling them to the highest bidder. While no one lugs commodities into the marketplace anymore, their producers may still hold out for the highest price they can get.
The commodities market has its own unique lingo. The commodities themselves are called “actuals.” “Insight” means the actuals underlying a commodity futures contract are about to be physically delivered. And a “break” refers to a natural occurrence (like a tornado or an unseasonal frost) that negatively affects the commodities underlying a futures contract.
Though this class of investment is riskier than other classes, holding commodities in some form (even in a mutual fund) adds diversification and some inflation protection to a portfolio.
Some investors prefer to go straight to the base of the production chain, buying re- sources directly rather than investing in the companies that use these resources— or commodities, as they’re called in the investing world—to make consumer products. Commodities are natural resources, the raw materials used in all means of production. Examples of commodities include:
- Lumber, which is for much more than building houses.
- Oil, which impacts more than just transportation costs.
- Cotton, which is used in many items, from clothing to coffee filters.
- Wheat, the main ingredient in hundreds of foods.
- Corn, which can be found in foods, building materials, and biofuels.
- Gold, a precious metal used for much more than making jewelry.
While commodities themselves can be bought and sold directly, they are often the underlying investment for futures contracts. And while most individual investors don’t buy bulk commodities, they can invest in commodities through mutual funds and ETFs.
- A No-nonsense Guidance For Beginners In ETFs Investment (Exchange-traded Funds)
- Investment For Beginner: What Is Mutual Fund And How Do They Operate?
Precious metals, gold, in particular, are exceptions to that individual investing rule. Millions of investors throughout the world buy and sell gold, though many more invest in this commodity through stocks (in mining companies, for example) and precious metals funds. Investors who buy and hold gold, believing that the metal will maintain good value over time, are called “gold bugs.”
The Golden Way
Gold is a lot more than a beautiful shiny metal that looks good around a neckline or surrounding precious gems. Gold is also used in many other types of products, from medical machinery to aerospace equipment to glass. And, of course, it’s been used as currency for more than 3,000 years.
Investing in straight gold can take a few different forms, such as buying gold bars or bullion coins. Gold bullion is pure, raw gold, before it’s ever been shaped into a bar or a coin; very few (if any) individual investors hold straight bullion. Gold bars are what most people think of when they think of gold: stacks of gold bricks. Gold bars must be made of at least 99.5 percent pure gold bullion, as measured in karats. Most gold bars weigh a uniform 400 troy ounces (which is the standard used to weigh gold), though you can find them as small as a single standard ounce. Gold coins, or bullion coins, are real currency made out of solid gold. Though they’re rarely used as currency anymore, these coins have definite value, usually more than just their worth in gold. Most investors choose to own gold coins, often taking great pride in their collections.
People can invest in other precious metals as well. Silver, platinum, and copper (just to name a few) are also bought and sold by investors, often in coin form. These metals don’t have the same trading value as gold, though they are much sought after by industry for production purposes.
OPTIONS FOR CURRENCY AND COMMODITY TRADING
Investing in the Future
An option is a marketable security that gives the holder the right, but not the obligation, to buy or sell another security at a specific price by a certain date. The essence of the option is that it’s a bet; if you’re an option holder, you are betting that the price of the underlying security will move as you expect (up or down), and as much as you expect. They don’t necessarily care which way the price moves, as long as it moves. And though most people associate options with stocks (i.e., stock options), options can be written for virtually any kind of security that exists. However, since stock options are by far the most common, this chapter will focus on them.
Listed options are those that trade on the Chicago Board Options Exchange (CBOE) or another national options exchange. These options all come with fixed expiration dates and strike prices. In addition, every listed option represents a contract to buy or sell 100 shares of stock.
Before we get to the ins and outs, you need to learn the basic language of options. The two most important terms are put and call.
A put option is for selling. A call option is for buying. Both types of transactions are carried out on the asset underlying the option. When you decide to buy or sell, you’ll be exercising your option. The security price specified on the option is called the strike price. Long-term options are called LEAPS.
A stock option comes with a specific stock as the underlying asset. Stock options give you the right to buy or sell (depending on the type of option) a specific number of shares of named stock for a preset price within a preset time period. For example, you could buy a call option that would allow you to buy 300 shares of ABC Corp. for $50 one month from today. If the market price of ABC is $60 in a month, you would exercise your option and buy 300 shares of ABC at $50 (then turn around and sell them at $60 for a nifty $3,000 profit, $10 times 300 shares).
On the other hand, if the stock price is only $45 next month, you would let your option expire. After all, why would you pay $50 for shares you could snap up for $45?
Investors can also create, or write, options, as opposed to buying them. In that case, the option writer offers someone else the opportunity to buy or sell an underlying security at a named strike price. If the option holder chooses to exercise the option, the writer is obligated to fulfill the options contract.
If you have an option, you have virtually unlimited profit potential, and your losses are limited to what you paid for the option. A stock option’s value is determined by five principal factors: the current price of the stock, the strike price, the cumulative cost required to hold a position in the stock (including interest and dividends), the time to expiration (usually within two years), and an estimate of the future volatility of the stock price.
Some investors prefer a long-term view, and they may purchase longer-term options known as LEAPS (Long-Term Equity Anticipation Securities). LEAPS typically don’t expire for two to three years, sometimes as long as five or ten years. Other than that key distinction, LEAPS trade like regular options. Though they trade just like standard options, they are not as widely available. You can get them on most heavily traded stocks, but they are not written on as many different stocks as short-term options are.
Employee Stock Options
You may have heard about—or even received—employee stock options. These stock options are given by a company to its employees (usually top-level employees as part of their overall compensation packages) based on the company’s own stock. In some industries, even lower-level employees may be offered stock options, especially in the fast-growing sectors like biotech.
These options give employees the incentive to work harder and help make the company even more profitable. They are often used as an incentive to lure quality employees to the corporation.
The U.S. futures markets came about to help farmers stabilize grain prices, both in times of surplus and times of shortfall. That way, when crops are scarce (during the winter, for example), prices won’t get prohibitively high. And when crops are plentiful, farmers won’t have to sell their produce so low they can’t buy supplies for the next year.
Employee stock options are different from regular options in that there’s no third party writing the contract. Instead, it’s a direct agreement between the issuing corporation and the option holder. In addition, employee stock options are often tax-advantaged, an added benefit for both the company and the employee. Another key difference is in the time frame under which these options can be exercised: Employee stock options usually must be held for a minimum time period (often more than a year) and can be exercised over long time periods, even as long as ten years.
Futures contracts are among the riskiest investments in existence. While buying futures is (in practice) as easy as buying stock—you just call your broker, place an order, and pay a very hefty commission—the potential consequences are nowhere near the same. Unlike options, when you purchase a futures contract, you become obligated to buy or sell the asset (usually a commodity) named in the contract, by a predetermined time for a set price. Futures contracts are most often written on agricultural products (like pork bellies and corn), energy products (like oil), precious metals (like silver and gold), or currencies.
Futures traders stand to make piles of money when things go their way. But the downside can be financially devastating. If you guess wrong on which way prices are heading, you could end up on the hook for much more money than you invested in the futures contract. Remember, you will be contractually obligated to fulfill the terms of the agreement. For this reason, even the most risk-loving individual investors should stay away from the futures market unless they are confident that they have a comprehensive understanding of the underlying commodity, its market, and the way its market moves.
Betting on the Downside
When it comes to investing, you can divide the whole pie into two pieces: long and short. Long investing means you’re expecting the price of a security (usually a stock) to go up. Short investing means you’re betting the market price of a security will go down. Most people go long, but risk lovers often go short, knowing that they may reap spectacular returns when a corporation falls. Short selling is the practice of selling a stock (usually a borrowed stock) before you’ve bought it, and hoping the share price will drop so you can replace the borrowed shares with shares that cost less than the ones you sold. It sounds tricky because it is tricky, but an example with numbers will make it clearer.
When the stock market experiences a sudden, sharp decline, the government may put the kibosh on short selling. Since short investors want share prices to drop, their activity can actually cause further declines in an already falling market. To stop a market crash (and to boost investor confidence), short selling may be temporarily suspended until market equilibrium can be restored.
Let’s say Joe thinks shares of Exxon Mobile will go down very soon, and he wants to profit from it. Joe borrows 100 shares of Exxon from his broker and sells them for the current market price of $100. That means Joe just brought in $10,000. But he still owes his broker 100 shares of Exxon. If he’s lucky, Exxon shares will drop. If they do drop, let’s say to $90 per share, Joe can pick up the 100 shares for just $9,000, scoring a quick $1,000 gain. (We’re also assuming there are no transaction fees here, to keep the numbers simple.)
If the price doesn’t go down, Joe buys the shares at $100, hands them over to his broker, and breaks even. But if Exxon rallies and the shares climb to $101 per share, Joe’s out of luck. Now he has to pay $10,100 for those same shares, netting an instant loss that comes directly out of his pocket, and directly out of his portfolio.
Margin buying is related in the sense that it involves borrowing, and can also cause devastating losses that deplete an investor’s portfolio. The investor who buys on margin buys stock using a little of his own money and a lot of his brokerage firm’s money.
To buy on margin, you first have to have a margin account set up with your broker. Once you make a buy, the shares remain in the account as collateral on the loan. That sounds like a good deal, right? You get to buy more shares than you ever could on your own, and the shares themselves count as collateral for your loan. If everything goes your way, and the stock price goes up, it is a great deal. But if the price drops, you’re in a lot of hot water. Not only did you lose money on your investment, but you still owe the brokerage firm the money you borrowed to buy the stock, plus interest. Of course, the stock could rebound, but that doesn’t fix the current situation.
You see, to maintain a margin account, you’re required by law to have what’s called a maintenance margin. Federal law requires a maintenance margin of at least 25 percent; the balance of your margin account has to be equal to at least 25 percent of the value of the stocks you borrowed.
If there’s anything an investor dreads, it’s a margin call from his broker. Those come when a stock the investor has bought on margin drops in price. The shares in the margin account are no longer worth enough to cover the account’s collateral requirements, and the investor has to scramble to make up the difference.
An example with numbers will clarify. Suppose Jane wants to buy $10,000 worth of shares in IBM and wants to use only $5,000 of her own money. She buys the shares through her margin account, using $5,000 of the broker’s money, and the IBM shares are held in the account. The next week, IBM has dropped in value, and Jane’s shares are only worth $7,000. The balance in her margin account has now fallen to $2,000 (the current share price of $7,000 less the $5,000 loan), which is $500 less than the 25 percent maintenance margin. Jane either has to pony up $500 (which she’ll do if she thinks the shares will rebound) or sell the shares for a loss and pay off the loan.
Initial Public Offerings
Initial public offerings (IPOs) are exciting and frightening propositions, both for those involved in managing a company as it enters an IPO and for those who choose to invest in one. A company launches an IPO when it chooses to go public as a way to raise money, which means it will be issuing stocks to the public for the first time. By selling shares of its stock, a growing company can raise capital without taking on debt. Investors, in turn, expect to earn profits by purchasing stock in a company they hope will grow, eventually making the stock worth a lot more than they paid for it.
An investment bank—Deutsche Bank, for example—usually handles the detailed process of issuing stock. A company works with the investment bank to determine how much capital is needed, the price of the stock, how much it will cost to issue such equities, and so forth. The company must file a registration statement with the SEC, which then investigates the company to ensure that it has made full dis- closure in compliance with the Securities Act of 1933. The SEC then determines whether the company has met all the criteria to issue common stock and go public.
How to Get In on an IPO
The best way to find out about an IPO is to have a broker who is in on all breaking financial news. The NASDAQ website lists all recent IPOs as well as upcoming ones (www.nasdaq.com/markets/ipos). Companies awaiting an IPO often call the leading brokerage houses and/or brokers they are familiar with, who will inform their clients about such an offering. As is the case with anything new, these stocks can be very risky due to their potentially volatile nature. It’s a good idea to wait until the stock settles before you determine whether it would be a viable investment. The vast majority of stocks that you will be researching have probably already been actively trading.
Before the company has its initial public offering (IPO) and its stock goes public, the SEC must make sure that everything is in order. Meanwhile, a red herring is usually issued, informing the public about the company and the impending stock offering. When the stock is ready to go public, a stock price is issued in accordance with the current market.