An important question is: how much do we buy and sell? The obvious (and easiest) answer is to buy one contract of the undervalued commodity, and sell one contract of the overvalued. However, each commodity gives the owner power over a certain number of the commodity – one soybean contract controls 5,000 bushels, for example – and the values of these contracts might be different.

To give an example, let’s look at the soybean / soybean meal spread that we were looking at before. As the chart showed, the ratio of 3.631 looks lower than usual, meaning that soybeans are undervalued and soy meal is overvalued. A $1 move in the contract price of soybeans is a move of $50 in actual value; a $1 move in the contract price of soybean meal is a move of $100 in actual value. These can be calculated from the screen captures above – on the left is the “tick” size for soybeans, and on the right is the “tick” size for soy meal. As the ratio suggests, the two typically trade at a ratio of (roughly) 4 to 1 – that is, the price of the soybean contract will move 4 times as much as that of the soy meal contract. Let’s assume that tomorrow, the soybean contract moves up $4, and the soy meal contract moves up $1, in accordance with this ratio.

1 Soybean contract (SQ8): +$4 = +$200 actual value (since $1 move = $50 actual value)
1 Soybean Meal contract (SMQ8): +$1 = +$100 actual value (since $1 move = $100 actual value)

The goal of the ratio is to have offsetting positions that are roughly equal. If we were to execute this spread using one contract each, we would have twice as much value in the soybean contract as we would in the soybean meal contract. This means that we would be biased towards the soybeans, and if we were buying soybeans and selling soy meal, we would lose money if both were to drop in value, since the gains made in selling the soy meal contract would not offset the losses from buying soybeans. Thus, to make our positions offset (also referred to as creating a “zero-delta” position), we would want to buy one soybean contract, while selling two soy meal contracts.

So we now know that one potential mistake in trading a commodity spread is in trading contracts with different values. Another mistake that is easy to make is not giving yourself enough time for the relationship to come back into balance.

For those unfamiliar with futures contracts, contracts have expiration dates. Typically, multiple contracts, each with different expiration months, will be traded on the same commodity at the same time. The image below shows a “futures chain” or a series of contracts on the same commodity (in this case, soybeans) for various expiration months.

Contract symbols are constructed with the commodity symbol first (S for soybeans, in this case), then the letter corresponding to the expiration month, and then the number corresponding to the expiration year. Specific dates of expiration vary from one commodity to the next.

The lesson here is that it may take as long as two to three months for the ratio between the two commodities to return to your target value. If we were to execute this trade today, it would not be wise to use the August contracts, which will expire in 9 days. In this case, we would be forced out of our position, and would incur any losses that we may have accumulated by a temporary continuation of the trend away from the mean. A better choice might be the November contracts, to ensure that the correction will occur before the contracts expire.

Finally, as with any investment, it is important to set a goal for your trade, as well as a level where you will cut losses and move on. For example, “I will exit the position at a ratio of 3.75, and cut my losses at 3.55.” Set these boundaries for yourself before you enter the position – this will help you to avoid being emotionally attached to your investment, falling into a loss that your portfolio can’t afford, or missing out on a profit-taking opportunity.

You now know the basics of trading commodity spreads: buying the undervalued commodity and selling the overvalued, making sure that the positions are off equal value (offsetting), buying contracts with expiration dates that give you enough time to profit, and setting goals and limits. But why is the commodity spread a good play? Next time, I’ll introduce the many advantages of commodity spreads, particularly in volatile and uncertain market conditions such as those we face today.

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Matt Malkus is a statistics major at Virginia Tech entering his senior year, with more than 5 years of experience in equities markets, and has recently entered into the world of futures markets. He currently serves as the Chief Information Officer of the school’s Society of Individual Investors.

Positions in this article are the opinions of the author and guarantee no future gains. As always, investors are advised to take on only the amount of risk that their portfolio can comfortably handle.

Note: This will be part one in a continuing series of articles related to commodity spreads, offering advantages and disadvantages, potential mistakes, and detailed examples.

The world of commodities is a fast-paced, highly-leveraged world where gains and losses per day can be in the thousands, even in the smallest of trades. This offers unique advantages and disadvantages over equities, where one share is just one share, and its face value is what you pay. For example, the “face value” price of a soybean contract is currently at $1357.75 (and this is what you will pay to obtain it), this is the price of 100 bushels of soybeans. However, one contract controls 5,000 bushels of soybeans, making a change of $1 in the contract price a change of $50 in actual value in your position. A “limit” movement (maximum allowed) of $50 in the contract price means gaining or losing up to $2,500 in a single trading day on a single contract!

As such, if you can’t afford to lose a few thousand dollars on a trade, it is not advisable to purchase a contract outright without employing a strategy that greatly minimizes this risk (while, of course, also limiting the upside potential). One of the major upsides to dealing with commodities over equities in developing a strategy is the relationships present between multiple markets. In equities, for example, shares of technology companies may all move loosely together – but if Apple comes out with an earnings report, announces a new product, or hires a new CEO, it may not follow the broader sector.

In commodities, these factors are usually absent. Take, for example, the soybean market. A market on a physical commodity is much more dependent on simple supply and demand factors. Weather is a major factor in any agricultural market, as good weather means higher supply and lower prices, or vice-versa. The weather factors connect most agricultural commodities grown in the same areas – soybeans, corn, and wheat, for instance. However, even stronger relationships exist when we look at derivatives of the same crop: soybean meal and soybean oil are also traded commodities. This can be applied outside of agriculture, of course: precious metals (gold/silver), energy commodities (crude oil/natural gas/ethanol), and many other sectors also have commodities whose supply/demand structure are greatly influenced by others.

As an example, let’s take a look at the relationship between soybeans, soybean meal, and soybean oil since the beginning of the year. To do this, we will use the ratio of the prices of their contracts, by dividing the higher priced contract by the lower, and observing the value.

Soybeans August 2008 (SQ8): $1357.75

Soybean Meal August 2008 (SMQ8): $373.90

Ratio: SQ8 / SMQ8 = 3.631

By charting the changes in this ratio, we can see how strong the relationship is (by observing how stable or volatile the ratio is), and gather insight on when to act. First, though, we must know how to act. Since we are dealing with a relationship between two commodities, we will want to take advantage if this ratio is higher or lower than normal by creating offsetting positions. If a ratio of 3.631 is lower than normal, this means that soybeans are undervalued in relation to soybean meal – in this case, we would buy the undervalued commodity (soybeans) and sell the overvalued (soybean meal). If this ratio were high, we would do the same thing, buying soybean meal and selling soybeans.

Here’s a chart of the relationship between the soybean / soybean meal ratio (also called the “crush spread”):

As you can see, the ratio is quite low in relation to the trend since the beginning of the year. In this case, we might think about buying the undervalued commodity (soybeans) and selling the overvalued (soybean meal). Before you do, however, there are many potential dangers and mistakes which can easily be made by investors who are new to the world of commodities. In the next installment, I’ll point out some of these dangers and mistakes, and show you how to capitalize on a relationship like the one above, while minimizing the risk associated with taking the position.

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Matt Malkus is a statistics major at Virginia Tech entering his senior year, with more than 5 years of experience in equities markets, and has recently entered into the world of futures markets. He currently serves as the Chief Information Officer of the school’s Society of Individual Investors.

Positions in this article are the opinions of the author and guarantee no future gains. As always, investors are advised to take on only the amount of risk that their portfolio can comfortably handle.

Hedging against inflation

I am a strong advocate of, in a high inflation environment, holding 5-15% of one’s portfolio’s NAV (net asset value) in gold, silver, platinum, or palladium.  Such metals are a strong ‘hedge’ against inflation, meaning they almost always go up in value as a currency decreases.  There are a few methods of purchasing these metals, but I’d warn against purchasing an ETF linked to precious metal; true ownership is the best scenario in case of a market crash.  Both home ownership and overseas holding are the best two options, although the government has seized gold before.  If one is looking into purchasing gold/silver, bars are almost always better than numismatic purchases, as one does not pay the collector’s overhead on the coins.  That being said, there is also a good market in junk silver, where a large discount is to be had.  Be creative, and one can often purchase many ounces of silver at a significant discount to melt price.

Beyond gold and silver, one can also store some of their money in more well-managed currencies, such as the Swiss Franc.  This is a more complex investment strategy, but is easily accomplished through such online brokers as Interactive Brokers, who can put one’s cash deposit in any currency  within their Forex database.  Alternatively, one could hold the currency itself, but may find convertibility to be an issue.

Positions written about in the Free Investor are purely the opinions of Alexander Drummond and the Free Investor staff.  Tomorrow and Sunday, this series will be continued with a segment on Overseas Investment, as well as possible U.S. stocks that can survive economic recession.  Following that, the Free Investor will be on a 3 week vacation, after which we will transfer to a twice-weekly program with posts on Tuesdays and Fridays.

The above chart indicates exactly why many investors, smartly, look for stocks that pay dividends.  Dividends are simply a method for companies to deliver a portion of their profits to shareholders; however, the consistency and strength of a given dividend often reflects the strengths of the companies.  Investors often view dividend-paying stocks with greater confidence, as many investors see dividends as a constant measure for a given company’s accountability.

Perhaps one of the most powerful attributes of dividend-paying stocks is the ability to reinvest the received dividends back into shares of that company.  Many companies offer a dividend reinvestment program, commonly referred to as a DRIP, that purchases more shares of the company using every dividend.  Often, these programs also allow the purchasing of fractional shares using dividends, further extending the purchasing power of the dividends.

Such dividend reinvestment programs are often offered only directly from the company itself.  However, many full-service and discount brokers offer dividend reinvestment for all stocks, usually for free or at a marginal cost.  As reflected in the chart above, dividend reinvestment has the capacity to increase gains far beyond the growth of the share price alone.

That concludes this week’s Free Investor, as this is a holiday weekend.  Next week we will discuss some of the drawbacks of dividends, as well as some dividend-paying stocks that could have a bright future.

Why doesn’t this logic hold up? Long-term growth and broker fees.

Over the long-run, these volatile swings in the market tend to be corrected by general economic growth. Timing the market can work; however, many small investors are not quick enough to catch these trends in time to maximize earning potentials. Moreover, many investors fail to rationalize their reasoning for their purchase. Often enough, purchases have as much to do with an investor’s whims and emotions rather than a thorough analysis of fundamentals. As Benjamin Graham, the famed value investor, once said: “The individual investor should act consistently as an investor and not as a speculator. This means.. that he should be able to justify every purchase he makes and each price he pays by impersonal, objective reasoning that satisfies him that he is getting more than his money’s worth for his purchase.”

What can an investor do to avoid dangerous sell-offs like many made yesterday? Detach one’s self from the market. Purchase securities for their long-term growth potential. Better yet, purchase an index fund or ETF. SPDR (SPY) track the S&P 500, whereas Vanguard Total Stock Market (VTI) tracks the entire market itself. Either should provide, over the long-term, growth rates higher than that of the average investor. Since 1950, the S&P 500 has returned 8.66% per annum. Such a rate would mean that one dollar invested in the S&P 500 in the year 1950 would be worth $65.27 today.

Furthermore, make sure that your broker fits your need. With a long-term growth strategy, it makes little sense to have a full-service broker. Many full-service brokers, as well as some discount brokers, charge inactivity fees. These fees can range from $40 to $400 per year. Such a cut can be a significant portion of a client’s portfolio, and is removed regardless of performance.

As you are a long-term investor, stock transaction fees should not matter an incredible amount. However, it would still be advisable to find transaction prices below $15 a trade. Some online brokers, such as Zecco, now offer $0 trades to their investors. Another worthwhile feature of online brokers is automated dividend reinvestment; every dividend received is invested back into stocks as you indicate, compounding your growth further.

Next week, we’ll analyze high-dividend stocks, and why they’re often overlooked. Make sure that this week, which will perhaps bring further drops in the market, does not necessarily create a poor situation for us common investors. Rather, look at it as an opportunity for us to get into the market at a low-point. That does not mean we are entering a bull-market, as it is best to remain highly cautious during these severe dips. However, it is best to take a non-emotional approach to our investing, and remember the long-term outlook.

Alexander Drummond owns none of the stocks mentioned in this article.

First and foremost, I would like to thank Marc and Liberty Maven for the fantastic opportunity to write here at Liberty Maven. To begin, I will make the first disclosure of many to come: I am not a financial advisor. None of my suggestions are firm recommendations of securities or properties to be purchased; I encourage each and every investor to do their due diligence in investing by thoroughly researching every asset before purchasing or divesting.

That being said, I will give you some background information about myself. I am currently a student at the Illinois Mathematics and Science Academy in Aurora, Illinois. I am the president of the Teenage Republicans group, as well as the founder and president of IMSA Entrepreneurial Engineering Club. Over the past 4-5 years, I have studied the financial world with intense concentration, and have begun to advise my family as to financial purchases in the past year or so.

As for the focus of this segment, there are two main components upon which I will construct this series. First, and foremost, is my personal belief that there is a dependable, long-term growth strategy available for each investor. This growth is primarily available to those employing buy-and-hold strategies in market index funds. I am not a fan of individual investors dabbling in options or penny stocks. The commission fees are atrocious for many small investors, and over the long run, rarely deliver the type of return that a proper retirement necessitates. I will expand on this in future installments.

Secondly, I would like to focus on ‘liberty’ investments. Many who support Ron Paul and other like-minded candidates often advocate for investing in precious metals, as a hedge against inflation. I would like to discuss other alternative hedges against inflation, as well as reasons why gold may not be the best investment for every individual. Beyond that, I would like to concentrate on companies and charities who have shown themselves to be strong supporters of freedom.

Most importantly, this column is about you. The more questions and comments we receive, the greater amount of material that I can discuss in future installments. By either posting in the comment section or e-mailing me, we can start a dialogue about an particular investment you may wish to discuss, as well as the market in general. It is a tough time for many investors, but by framing the current investing paradigm properly, and looking into the long-term, we can develop a strategy for long-term, stable yields. I hope you enjoy The Free Investor.