Not Your Grandfather's Commodity Market

The Daily Reckoning PRESENTS: With the age of electronics, everything changed. Even the stodgy old commodities market. Kevin Kerr explains how these innovations have changed – and advanced – the world of trading. Read on…

NOT YOUR GRANDFATHER’S COMMODITIES MARKET

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 them…one 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.

Regards,

Kevin Kerr
for The Daily Reckoning
March 7, 2007

Editor’s Note: 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.

It was a necessary and obvious decision to bundle all of our commodity-related publications together in one easy package so you can effortlessly take advantage of the next leg of the massive commodity super boom. For a very limited time, you can take advantage of a special offer that allows you to get all of our research services that are devoted to resources and commodities – for life

The above was taken from Kevin’s soon-to-be-released book, A Maniac Commodity Trader’s Guide to Making a Fortune. In the book, Kevin dispels the common myths and misconceptions about these markets, offering an insider’s view of what he calls “the last bastion of pure capitalism on Earth.” Whether you’re a novice or an experienced trader, Kevin’s down-to-earth, clear-cut guidance will make you more savvy, more confident, and more able to jump right in and grab those profit opportunities that are waiting for you. The book is available for pre-sale here:

A Maniac Commodity Trader’s Guide to Making a Fortune

“Goodbye America” says the page-three headline in this morning’s Metro newspaper.

After 66 years, the story reports, Marvel Comics, is finally laying to rest our hero, Steve Rogers, a.k.a. Captain America. The superhero has beaten the Nazis, the commies, terrorists and mutants. But he was brought down by a sniper’s bullet as he left a courtroom.

R.I.P.

But it was time for him to go. Captain America was invented to defend the land of the free. But now, after the War on Terror…the Patriot Act…and the Prescription Drug Bill…what freedom is left? We are free to dye our hair purple, dress up as a priest and wed a two-headed calf. But that is not the freedom we once looked for.

And so it goes. Every great empire begins in deceit, develops into farce and ends in disaster. The farce – at a high point in the Clinton and Bush administrations – has been great fun. But in order to see what lies ahead we have to be looking far behind. And if we look far enough behind, what we see is old Rome in grand decline. Mind you, it was not a bad time for a man with money and a villa on the coast of Dalmatia. But it was a very sad one for someone who had to rub against the sweating masses thronging the center, or try to hold back the barbarians crowding the periphery.

The Roman emperors spent too much money – on war, on bread, on circuses. They had to clip the coins, rob the citizens, and squeeze the whole empire for tribute to keep up with it. But it couldn’t go on forever. The barbarians grew bolder while the empire’s own forces weakened. Finally, the Vandals swept across the frontier and brushed aside the remaining defenders, and Rome itself – the capital city of the greatest empire in history – was sacked.

It is an old story, dear reader. Does it tell us anything useful about the future?

“If there is one thing that can bankrupt America, its health care,” said Comptroller General David Walker.

Walker has been giving speeches lately, warning Americans that they are spending too much money. On ’60 Minutes’ recently, he explained that the Bush administration’s Medicare Prescription Drug Bill was the single most disastrous piece of legislation to come along in many decades.

At the center of America’s empire is a jolly pack of clowns, liars, and cowards. As to the prescription drug bill, the Bush administration told the nation that it would cost $400 billion in its first 10 years. Now, says Walker, the bill is sure to be closer to $1 trillion. At the present rate of growth, he explained, Medicare and Social Security alone will take up the entire federal budget by the year 2040.

That obviously wouldn’t leave much money for keeping the barbarians outside the gates. But here, too, the dissemblers rush in to back up the fools. It was foolish to waste the nation’s troops and treasure in a messy war in Mesopotamia. Rome did it…and regretted it…more than once. Now, American centurions patrol the streets of Baghdad while the Caesars on the Potomac inflate the casus belli – all the while deflating the cost estimates.

What happens? What gives? How does it end? We can tell you. Farce gives way to disaster. Sooner or later, the commitments can’t be met. The total value of all the household wealth in America is about $50 trillion – about the same amount as the total net ‘financing gap’ of the Federal government. Which means, dear folks, we are already broke.

But it is not only the feds whose spending is out of control. The U.S. trade deficit, born out of runaway consumer spending, is also careening down a winding road at top speed. Each year, the deficit effectively transfers more U.S. capital to foreign hands. According to figures we found yesterday, now more than half of new federal debt is going to foreigners.

The U.S. current account first went negative in the mid-80s…about the same time that Alan Greenspan took over at the Fed. But it took another 20 years before the total of U.S. assets in foreign hands was so great that the net income from overseas investments turned against the United States. That milestone was passed last year.

Warren Buffett described the situation in his annual report to shareholders last week:

“The ‘investment income’ account of our country – positive in every previous year since 1915 – turned negative in 2006. Foreigners now earn more on their U.S. investments than we do on our investments abroad. In effect, we’ve used up our bank account and turned to our credit card. And, like everyone who gets in hock, the [United States] will now experience ‘reverse compounding’ as we pay ever-increasing amounts of interest on interest…

“Our citizens will also be forced every year to ship a significant portion of their current production abroad merely to service the cost of our huge debtor position. It won’t be pleasant to work part of each day to pay for the over-consumption of your ancestors. I believe that at some point in the future, U.S. workers and voters will find this annual ‘tribute’ so onerous that there will be a severe political backlash. How that will play out in markets is impossible to predict – but to expect a ‘soft landing’ seems like wishful thinking.”

Empires do not typically land softly. They blow up…loudly.

More news…

————–

Chuck Butler, reporting from the EverBank world currency trading desk in St. Louis:

“Great… Here we go again, throwing out the protectionism shields and swords. It’s all fun and games with these guys until somebody loses an eye! Here’s the skinny…”

For the rest of this story, and for more market insights, see today’s issue of The Daily Pfennig

————–

And more thoughts…

*** Kevin Kerr, with a bit of advice for all you would-be commodity traders out there…

“The commodities markets are always in flux, and it’s important to keep up with new markets and new opportunities. Never judge a book by its cover. I remember in the stupidity of my youth being offered a natural gas seat to trade on the exchange for free. For free! I turned it down.

“You see, the badge was purple and my cotton badge was orange and if you own both, it makes your trading badge half purple and half orange, so I said no. Seriously, I said no because I didn’t believe a natural gas contract would ever be successful. After all, the commodity was tightly regulated and it comes through a pipeline controlled by spigot.

“Well, chalk this one up in my loser column; I know when I get to heaven and they are reviewing me for entry, this one will come up as one of the more foolish decisions of my youth. Today, natural gas is a highly liquid and sought-after seat; I won’t tell you how much the seats go for. You just never know what the next hot thing is going to be, but it may be the thing you least expect.

“Always study the markets you want to enter – take an interest in them. One of the most important things in this business is to be interested in what you are trading. Otherwise, trading becomes a chore. I personally don’t trade Treasuries – why? Not because they’re not good markets but because they don’t really engage me. Others couldn’t care less to trade sugar; I, on the other hand, am passionate about it. That’s the key: Be passionate about the market you choose to follow, but never let emotions cloud your judgment.”

*** A reader poses a very good question: “How can you continue to expect gold to go to $1,000 an ounce when the world is entering a deflationary meltdown?”

The answer: We don’t know what the world is doing…apart from shivering and shaking. It’s got a fever from excessive exposure to liquidity. How this illness will progress we are not sure. All we know is that the epizootic will have to run its course. And we presume it will include spells of hot flushes from inflation as well as cold, damp, teeth-chattering deflation. The inflation is likely to send gold up in price. The deflation is likely to send it down. But at some point, the fever will break. Many paper assets will probably be dead by then.

As to the value of the dollar, relative to gold, we can’t say. But when you enter one of these periods of grave illness, the goal is to survive. Maybe you will be able to make some money out of the general suffering and cluelessness; maybe you won’t. But gold will probably help you survive, and probably leave you in better shape than most other investors. That is about the most you can hope for, in our opinion. As to what price gold will sell for – during and after the ailment – we can’t say.

*** We were trapped on the train today. The Eurostar lost power. We sat. We waited. Finally, the conductor announced that we were on board the poor little train that couldn’t, and that another train would have to come along to take us to our destination.

This left us in the compartment…sitting. We found that we were surrounded by a group of American girls, apparently part of a school group. They were all very plump, all dressed in jeans, white running shoes, assorted t-shirts, sweatshirts and sports jackets.

We couldn’t help but listen to their patter.

“And I was like…yeah…all right.”

“And he was like…well I don’t care…”

“And I was like…okay…”

“And then I like said, well forget it.”

A dark cloud passed over our spirits. How did a group of youngsters come to be so fat and foolish, we wondered? Normally, it takes many years to get that way. What will become of them as they grow older?

*** “I hadn’t thought about it before. But now that I think about it, the idea is a little frightening.”

It was Elizabeth talking; and what she hadn’t thought of before was the possibility that we might sell our farm in Maryland and never move back to America.

We have lived overseas for more than 10 years. We have gotten used to it. As the years pass, the canyon between us and modern American culture grows wider. We don’t know who Antonella Barba is. Who’s John Popper? Or Lance Bass? We don’t know. We don’t care. Who won the Super Bowl? We couldn’t tell you. Who’s leading in the next presidential race? You would know better than we would, dear reader.

Most people know who they are and where they belong. But when you take leave of your mother country, a number of questions arise.

Elizabeth went on, “I don’t know…I always thought that we were going home some day. I always thought we were Americans who were spending a few years overseas.

“But now I see what you mean. America has changed while we’ve been gone. And we’ve changed too. I’m not sure why we would want to go back. But the idea that we won’t go back leaves me wondering who we are…what we are…where we should be.”

Generations of immigrants came into the United States to become something different. They gave up being Pols and Italians and became Americans, as quickly as possible.

But when we moved to Europe, we never intended to stop being Americans. We never wanted to become French. Our children never expected to become Europeans. We were Episcopalians from the sovereign state of Maryland and expected to stay that way.

“I don’t know, Dad,” said Jules recently, on a call from Boston, “there’s a whole group of French kids here. I spend a lot of time with them. Maybe we stayed in Europe too long. I don’t have much in common with these American kids.”

“If we’re not ever intending to go back to America…what are we? Are we still Americans?”

We thought about it. The idea of the expatriate has been around for a long time. The British had long experience with it when they were still in their imperial chips. They often lived in Africa or Asia…but as Englishmen. They got their papers from London…had tea at 4:00…and became, in many ways, even more English than the people they left behind. They kept up their ties with England too…sent their children to school there…and always expected to go home.

So too are there many thousands of expatriate Americans who read the International Herald Tribune…vote in U.S. elections…have children in American universities…and look forward to the day when they will return to the 50 states and collect their pensions.

But over time, the ties grow weak.

“But then, if you aren’t what you came from, what are you?” Elizabeth continued.

“What do you believe? What group are you a part of? How can you describe yourself – even to yourself? When people ask what we are, I say ‘American.’ What would I say…’Well, we used to be American’? But if so, what are we now…? I don’t think I’m ready for this…maybe we just need to go home.”