Trader Vic on Commodities

What’s Unknown, Misunderstood, and Too Good to Be True

Although potentially the commodities markets could sustain their gains for a long period of time, it seemed inevitable to me that when it came to the general public, more money would be lost on the way down than could possibly be made on the way up. This might seem to fly in the face of the fact that the commodity futures markets are by rule a cyclical business, but when you separate out the producers and large-size professional speculators, over time the public gets burned time and time again. Like the dot-com boom and bust, preceded by the biotech boom and bust, and the countless bubbles before that—all the way back to tulip bulbs— the pyramid scheme of commodities speculation would in the end leave a bitter taste in the mouths of many of those who got suckered in. The more I thought about the idea of this book, however, the more it began to appeal to me. First of all, this book would give me the opportunity to explain in rather simple terms how these markets operated, in order to remove some of the unknown mystique and misunderstood uncertainty involved. The more educated the investment community can become, especially the small investors, the less likely it is that they will be taken in by less-than-reputable advisors peddling their newsletters or “win big” strategies. Second, I would be able to debunk some common myths about commodities and various trading programs. It never ceases to amaze me how the same ideas return time and time again, gaining favor for a short period until the losses pile up and “experts” burn through one list of clients, preparing to build a new one. If understood thoroughly, futures trading is not really that complicated—no more than Texas Hold’em. And it should be played in a similar fashion—bet on the hands statistically likely to win, or fold your losing hand as soon as possible. In fact, in almost every category commodities are actually easier to comprehend than options trading. Aside from the dangers of losing much more than the amount “invested” because of the margin rules and the incredible leverage commodity futures provide, they are quite simple to trade. For example:
Short sales can be made without the necessity of borrowing that stock entails.
Many markets can be traded 24 hours a day to some degree, due to common markets throughout the world and through the use of electronic marketplaces such as Globex.
There is always a cash market to compare the futures price to, so unlike many equities, the market price must in most respects be tied to realistic forces and factors.
From an individual’s perspective, futures should be easy to comprehend. The price of a pound of sugar or a gallon of gasoline is something every person can relate to, while the compounded annual growth rate of a multinational corporation, or the year-over-year same-store sales for a chain of jewelry stores might be more difficult for average investors to wrap their minds around.
Perhaps most importantly, futures trades are marked-to-the-market on a daily basis. When a position moves in your favor, you’ve made the money, whether you choose to close out the trade at that point or not. Likewise, losses are incurred immediately. This forces an investor in the futures market to constantly reevaluate positions and the rationale behind each of them. This eliminates the “I’ll wait for it to come back” mentality, which results in people winding up with accounts full of worthless penny stocks, good only for tax-loss sales at the end of the year.
Commodities don’t go bankrupt like some companies do. But because they are cyclical, you must adopt a long and short strategy to generate returns above T-bills. For example, corn was $0.80 a bushel in 1930, and as I write this is $3.68 a bushel. That’s only a 2.0 percent compounded return in 77 years. In the last 37 years, corn has traded almost exclusively between $1.50 a bushel and $5.50 a bushel (except for a spot price spike in the mid-1900s), passing $2.50 75 percent of the time (see Figure P.1). Perhaps that is fair value?