Commodities Are Not Stocks

By Matthew Hougan

With all due respect, Jim Wiandt is just wrong here.

Jim is assuming that all the players in the commodities market are investors, and that's simply not the case.

Let's say I'm a farmer. I grow corn. I know pretty well what my costs are for next year: I know that I'll pay $X for seed, $X in real estate taxes and $X on fertilizer and water. But because corn prices are so volatile, I have no idea what price I'll receive for my crop.

Now suppose I can use a commodity futures contract to lock in a price of $5/bushel. At $5/bushel, I can meet my costs, pay my employees, and have enough left over to go on vacation for a week in Florida. I'm happy with $5/bushel. That futures contract acts like "price insurance" for my business. And like any insurance, I'm willing to pay a premium to buy it.

The existence of these players and their willingness to pay insurance-like premiums is just one of the things that changes the nature of the commodity markets.

Commodities are not stocks. The same rules don't apply.

Comments

[User64738:]

I'm not sure what insurance you buy...
There are so many factors that I'd say you get very little insurance. In an ideal world yes but not in the real world.
It can be argued both ways, that it's a liability.
Say we hit inflation and your $5 next year is worthless. You'll be forced to sell at a price that's not market.
Or global cooling kills your crops and you're now stuck with $5 - negative.
Very similar to equity.

2008 Dec 23 05:07 PM

[wise:]

good and timely point

2008 Dec 24 10:51 PM

[markg:]

Good points, more than crop insurance, which is a seperate purchase, you lock in a price for your crop. This is a definite plus when there are bumper crop years, as was the case until recently. Look at monthly commodity charts for grains, you will see weakness until 2007 in the last ten years.

Most savvy farmers will also use options to deal with volatility. If $5.00 for corn is a target, you buy put options that have a $5.00 strike price, or slightly higher. That way if the price does go higher than $5.00, you still make out. If it drops below $5.00, you still have your $5.00 crop price and little loss, relatively speaking on the option.

2008 Dec 30 02:20 AM

[silver-bullet:]

The futures price is more than an insurance. It is a guarantee that another party is [committed] to take delivery at an agreed upon price at some point in time in future.

Unless the world stops eating corn, rice; stop using oil, cease to build buildings, then the futures contract becomes worthless.

The main point to take away is, commodities are [tradable]; and this feature by itself puts it on the same playing field as REITs, stocks, bonds, currencies, TIPS and all other asset classes.

Why else does a commodities exchanges around the world exists for?

Jan 01 02:59 PM