Not Your Grandfather's Commodities Market

By: Kevin Kerr | Fri, Mar 9, 2007
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Over the last decade the commodity markets have changed to the point that to some they may be unrecognizable. Since 1848, the open outcry and hand signal method of trading on commodity exchange floors was the only way to go. Enter electronic trading in the early 1990s, and soon the old auction method looked as if it were about to die any minute. Add the Internet and easier access to these markets by individuals, and it was bye-bye trading floor, hello computer screen.

We all know that didn't happen, and I personally believe it won't happen. But we can't deny that the electronic era is here to stay.

Today's trading methods aren't your grandfather's, and neither are today's markets. The markets we see actively trading today may not be the only ones we will see trading five years down the road. We may see alternative energy commodities such as ethanol take off from their infancy. We may see markets like corn and sugar explode because of ethanol demand. We may see new contracts for such things as water. We've seen commodity exchange seat prices jump, and we've seen the world scramble for resources. The explosion in commodities and natural resources over the last few years has been remarkable. As a nearly 20-year veteran of these markets, I have never seen anything like it- and it's showing little sign of slowing.

There are certain commodities that are staples of trading and most all investors should know these sectors and be very comfortable with of them being, of course, gold.

"All That Glitters"- that's what the old COMEX marketing line was. Back when I started trading, the COMEX was the top exchange in New York, the crème de la crème. The badge was green in color, and it took a lot of "green" to get one. At the time, a seat on the COMEX also was the most expensive seat on the New York exchanges, of which there were really four: the Coffee Sugar and Cocoa Exchange (CSCE), the New York Mercantile Exchange (NYMEX), the New York Cotton Exchange (NYCTN), and the Commodities Exchange (COMEX).

Chicago markets like the Chicago Board of Trade (CBOT) and the Chicago Mercantile Exchange (CME) were viewed as being on an even higher plane, and most Chicago traders considered the New York markets to be second-class citizens. Now much of that has changed. But as I arrived on the scene, a pivotal shift was happening: As the NYMEX began to grow in stature, the COMEX became a bit more tarnished.

The Hunt brothers' silver debacle, after their attempt to corner the world silver market in early 1980, drove many investors away from the metals, and some never returned. Today, however, the metals have come full circle, and silver, which for most of my career traded in the $5 to $7 range, is now busting out to new highs almost monthly. For many years, gold was simply a hedge against inflation, but not anymore; today, the shiny yellow metal is being sought as a flight to a quality instrument but also for its uses in jewelry on a large scale. The new gold exchange-traded funds also have helped to drive the price of gold higher, as these new instruments are backed by physical gold.

E-gold is another phenomenon that is not just fantasy anymore. Gone are the ideas of returning to barter using gold nuggets. Today's modern commerce allows the exchange of electronic gold credits between parties all around the world. This virtually eliminates currency risk and opts for one currency: gold!

The metals markets can be very volatile, and one strategy for capitalizing on the long-term rise in gold is to use options- specifically, long-dated gold options that may seem very far out of the money. FYI: An option is the right, but not the obligation, to buy or sell something (called the underlying- in this case, gold futures contracts) at a specific price, before the expiration date of the option. A long-dated option is one that expires a long time into the future. For example, as I write this, gold is trading in the low $600s but had been over $700 an ounce. It's quite possible gold could surge to $1,000 an ounce, and any traders worth their badges would want to be in on it! So to play this right now (with gold at $623), we would add the $950 call options.

They would be considered quite far out of the money. There's one of those pesky trader terms again. Let me clarify. In dealing with options, when you buy an option and the current futures price is below your option's price, it is called buying an out-of-the money option. When the futures trade up to the price of your option, it is called an at-the-money option, and when the futures price is above your option's price, it is called an in-the-money option. As I was saying, a $950 call option would be considered way out of the money if gold was currently trading at $623, but all that could change if gold rallies to new highs.

Meanwhile, by buying gold options, my risk potential is limited to the premium (price) I pay; I can't lose any more than I initially invested. It is one of the safest ways to invest in gold.

On to silver...

For years the silver market has languished in a narrow range with little momentum and not much of a bright future. Unlike its golden counterpart, silver has been more like the redheaded stepchild of precious metals. Not anymore.

This often maligned metal is up a whopping 60 percent since the beginning of 2005, and so far 2006 is looking good, too. There are many ways to play silver, just as there are for gold: silver bars, ingots, coins, jewelry, certificates, stocks, futures, and options. All have advantages and disadvantages, but the one we want to add to our portfolio is silver options.

Silver closed at its highest level in more than 22 years recently on hopeful expectations that the Securities and Exchange Commission would soon approve a silver-backed exchange-traded fund. This silver ETF is similar to the gold futures-based funds, streetTracks Gold and IShares Comex Gold Trust. According to reports, investors hold more than 14 million ounces of gold in the ETFs - that's significant because it's equivalent to about a fourth of last year's worldwide supplies.

In 2006, silver had an incredible performance in my portfolios and those of my readers. The launch of the silver ETF drove silver prices up several cents, and seemingly out-of-the-money options were tripling and quadrupling in price. In less than a two-month period, our positions were returning unheard of 400 percent profits and went even beyond that.




Kevin Kerr

Author: Kevin Kerr

Kevin Kerr
for The Daily Reckoning

Kevin Kerr is the editor of two highly successful and acclaimed financial advisory newsletters, Resource Trader Alert and Outstanding Investments. A veteran commodities trader, Kevin uses his irreplaceable experience to advise his readers on a variety of commodities investments on a daily basis. Widely considered one of the nation's top commodities gurus, Kevin's expert opinions are routinely featured in the country's premier media outlets.

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