Tharp's Thoughts Weekly Newsletter

The Van Tharp Institute   -  www.vantharp.com

June 13, 2007 — Issue #325

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Article

Playing the Commodities Boom, by Darrell Jobman

Trading Education Learn the Tharp Concepts
Trading Tip

Obscure News, by D.R. Barton, Jr.

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Melita's Corner

Egg on Your Face, by Melita Hunt

 

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Feature

Playing the Commodities Boom
By Darrell Jobman

Commodities have become an attractive investment in recent years, even for those who may not know much about them but would like to participate in the profit potential from dramatic price advances posted by energy, grains, metals and other commodities, lifting them to the highest overall levels in more than 30 years. 

Fundamental factors based on simple supply and demand account for much of increased price activity, of course, but other factors are behind these price moves as well. These are factors you should understand if you are one those investors thinking about putting some of your money into commodities. Although commodities are a hot topic for investors, it is also an area where newcomers can get stung if they are not aware of some pitfalls that can trap the unwary.

So let’s first look at some of the factors promoting this increased interest in commodities and then, if you are interested in trying to tap profit opportunities in this area, we'll look at some instruments you can use to exploit this possibility. 

Getting ‘Real’

You are probably well aware of the “dot.com bubble” that took stock market indexes to record-high levels in the late 1990s into early 2000. The stock market was the place to be for many investors, evident by the growing amount of money that poured into mutual funds, 401(k)s and other investments tied to the value of stocks. Investors enjoyed the run of a bull market since 1982 as they focused on investments in paper instruments rather than physical products.

As with most meteoric rises, however, the accelerated rise in stock prices at the end of the 1990s couldn’t last forever and they began to fade. Then came the Twin Towers disaster on Sept. 11, 2001, the follow-up U.S. war on terror marked by armed incursions into Afghanistan and Iraq, accounting and other corporate fraud scandals (Enron, Worldcomm, et. al.) and a slowdown in global economies, all of which contributed to a decline in stock indexes, especially those reflecting technology stocks. 

Many investors became disenchanted with prospects in stocks and began to look elsewhere to place their funds. Some put their money into housing and other real estate investments, causing a building boom and rapidly escalating property prices. China’s economic growth of more than 9% annually and the rebuilding required after two devastating hurricane seasons in a row along the Gulf Coast added to the huge demand for cement, copper and other building materials of all types (for more on the economic effect of hurricanes, see www.hurricaneomics.com). 

Oil’s key role

Adding to the expanding worldwide demand for commodities, the ongoing war on terrorism re-emphasizes U.S. vulnerability to disruptions in oil supplies from the volatile Middle East, and prices skyrocketed above $80 per barrel in 2006. The higher oil prices get, the more attractive alternate energy sources look. The favorite alternative that has emerged from the pack is ethanol, produced primarily from corn. 

With a big boost from Congressional mandates for ethanol production and usage, prices for corn began to shoot up last fall to the highest levels in more than 10 years, topping $4 a bushel after years of being closer to $2. Ethanol became the buzz word of the day, reinforced by President Bush’s comments about energy in his State of the Union message. When the government is pushing something, it’s best to trade in line with the government’s wishes, as interest rate traders know from watching actions of the Federal Reserve.

As demand for corn for ethanol grows, the higher corn prices may be driven and the more likely farmers will plant more corn at the expense of crops such as soybeans and wheat as crops compete economically for acreage. Livestock and poultry producers will also feel the effect of higher corn prices as will America’s grocery shoppers when they go to the meat counter.

 

After energy prices soared to record highs, copper was among the commodities that zoomed to new price heights in the first half of 2006 as housing and the Chinese economy sparked demand. While copper prices have since dropped back, corn and the grain markets are still on an ascending path in 2007, keeping hedge fund and other investors’ focus on opportunities in commodities.
Source: VantagePoint Intermarket Analysis Software (www.tradertech.com)

With what some describe as a “housing bubble” cooling and investments in stocks still not having overwhelming appeal, investors have turned to where the hottest action is – real things like commodities. Commodities have particularly become the darlings of a rapidly proliferating number of hedge funds, which can trade anything, adding further fuel to the general advance in commodity prices. 

Ready or not . . . 

Some commodities have backed off from their price peaks, leading some to believe that a “commodity bubble” may be breaking just like the bubbles in stocks and housing. Never has an understanding of intermarket relationships been more important to traders as the domino effect of commodity price moves extends throughout a number of commodities. 

Where prices of commodities now stand in the overall economic scenario is just one of the issues investors have to face today. With all the media buzz, is there still time to jump on the commodities bandwagon? If so, should you venture into futures or options based on commodities or get into one of the new commodity-based hedge funds or exchange-traded funds (ETFs) or invest only in stocks of companies involved in raw commodities? 

Commodity futures trading involves an agreement by an investor to purchase or sell a specific amount of a commodity for delivery at a specific time in the future. The key points are the price at which you initiate a trade and the time that is left until the contract expires, at which time both parties are obligated to fulfill the terms of the contract unless they have offset or liquidated their position. If you think prices will rise before the contract expires, you buy or go long. If you think prices will fall from the current level, you can sell or go short as easily as you can buy. 

ETFs are set up to achieve the same general return as an index – for example, the Spyders (SPY) ETF invests in all the stocks contained in the S&P 500 Index to mimic the results of the index. Commodity-based ETFs can invest in commodities directly through futures or in stocks from a sector influenced by what happens in commodities – a gold ETF based on a basket of gold mining stocks, for example. The advantages of ETFs are that they trade like a stock, don’t have the high leverage or risk that futures do and can diversify into a number of commodities or stocks that can dilute the effect of adverse moves in one commodity or stock. There is a very in-depth discussion on this very topic at www.TraderChat.com - the fastest growing online trading community.

Like any development that capitalizes on the hottest new trend, new ETFs are being offered every day. You have lots of choices so sift through them carefully. Some ETFs may be thinly traded so you need to understand what this investment can do before getting into it.

The commodities-related investment that may be most familiar – and, therefore, most prudent – for many investors involves investing in those companies that are most influenced by prices of commodities. If you think prices of copper will go up, for example, buy those stocks that would benefit most from higher copper prices. Ditto for oil prices or grain prices. Again, you have a number of choices so you will have to do your research to see which prices will mean the most to which companies.

 

After energy prices soared to record highs, copper was among the commodities that zoomed to new price heights in the first half of 2006 as housing and the Chinese economy sparked demand. While copper prices have since dropped back, corn and the grain markets are still on an ascending path in 2007, keeping hedge fund and other investors’ focus on opportunities in commodities.
Source: VantagePoint Intermarket Analysis Software (www.tradertech.com)

Futures pros and cons

Of the various choices, futures are the most direct play on price movement – and usually carry the most risk. The major lure of trading futures is the ability to make a large amount of money in a short time with a relatively small down payment. For example, to trade a 5,000-bushel contract of corn worth $20,000 with corn priced at $4 a bushel, the Chicago Board of Trade currently requires a minimum margin or good-faith deposit of $1,350 – less than 7% of the value of the contract. If you invest in stocks, you have to put up at least 50% of the value of the shares.

Every 1-cent change in the price of corn amounts to a $50 change in the value of a corn futures contract. If you buy corn futures and the price goes up 20 cents, your profit is $1,000. That’s a gain of nearly 75% on your initial margin of $1,350! And a 20-cent move in corn prices in today’s market conditions is very possible, sometimes in just one day. No wonder futures trading is so attractive to investors looking at commodities compared to other investment areas.

But beware. There is another side of the corn that a newcomer to futures needs to recognize before becoming involved in this type of trading. While the futures market can boost your account quickly, it can also diminish your account just as quickly. Commodities are generally much more volatile than stocks, making them a rough-and-tumble marketplace for the inexperienced. 

Timing is a critical factor in trading futures. In fact, you can be right about the direction of prices but wrong about the timing of the move and lose a significant amount of money. That’s true in any market but is compounded in futures due to the larger increments and high leverage involved in futures. Even a relatively small adverse price move against your position can deal a big blow to your trading account. 

You can set up a futures trading account at Merrill Lynch, Prudential Financial, Lind-Waldock, PFG or a number of other brokerage firms by signing disclosure documents and other forms and funding the account. 

Still, for those who can tolerate the risk, the possibility of large profits has an obvious appeal for investors seeking more action for their investment money. If you do decide to trade futures, you can improve your odds for success by first learning about and understanding how futures markets operate, then getting reliable information about markets and what is moving them.

Darrell Jobman, editor-in-chief for www.TraderEducation.com, has been writing about financial markets for more than 35 years, covering all aspects of the trading industry. A decorated Vietnam War veteran, he was a newspaper farm editor and editor of several agricultural publications before becoming an editor of Futures Magazine for more than 15 years. He has written and/or edited more than a dozen books on trading. His company provides free trading resources for futures, forex and stock traders. Check out www.TraderChat.com to meet other traders around the world and www.TraderBlogs.com to read the latest blogs from bloggers including Dr. Van Tharp. 

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Trading Tip 

Top Notch Internet Resources Part IX – Obscure News

By D.R. Barton, Jr.

Thanks for all of the e-mails about your favorite no-cost Internet sites.  Please keep them coming!  You’ll find my e-mail at the bottom of this article.

Today I’d like to talk about esoteric news.  How in the world do you find news on second and third tier stocks and even penny and microcap stocks – especially during the day?

I think briefing.com does a good job of covering almost every significant news item with their “In Play” feature, which provides streaming real-time news.  It’s sort of a “poor man’s” Bloomberg terminal.  (The Bloomberg terminal is the gold standard for news – and costs thousands of dollars per month.)

But this feature of briefing.com is part of the subscription service and we’ve been trying to ferret out the best no-cost sites out there.

And, even briefing.com, as good as it is, can’t cover every stock out there.  Besides, sometimes stocks make moves when there’s no news at all.  What’s a trader or investor to do then?

When you’re looking for news on a particular stock (on a no-cost basis), the first place I like to look is Yahoo! Finance.  They scan a comprehensive list of news providers and if any of the news services have run an article, you’re likely to find it there.

Not much new about that.  Just put the stock symbol in the box on the finance.yahoo.com home page and it will list the most recent news headlines (date and time stamped), in the center of the page, complete with links to the full story.

But what if there is no news, yet the stock has a big move one way or the other?  Go to the Yahoo! message boards.  You’ll find the link in the vertical menu on the left side of the page under “News & Info.”

But first, a few words of caution.  There are plenty of unscrupulous folks that use message boards as tout boards or for self-promotion.  If you have the patience to read through a few useless posts, there’s a high probability that someone will have a real explanation for what happened.

If you’re just wondering why something happened, then that’s probably all you need to do.  BUT – if you’re making investing or trading decisions based on this information, ALWAYS verify the information with a reputable source.  This is just the beginning of your source for the needle in the haystack.

There are some other message boards that are very good.  Motley Fool has a very active community, but I find that they don’t cover as many stocks as the Yahoo! community does.

Keep sending in your favorite sites to drbarton@iitm.com.  And let me know if you’ve found these discussions useful! Until next week…

Great Trading!

D. R.

About D. R. Barton: A passion for the systematic approach to the markets and lifelong love of teaching and learning have propelled D.R. Barton, Jr. to the top of the investment and trading arena where he is one of the most widely read and followed traders and analysts in the world. 

He is a regularly featured guest analyst on both Report on Business TV,  and WTOP News Radio in Washington, D. C., and has been a guest analyst on Bloomberg Radio.  His articles have appeared on SmartMoney.com and Financial Advisor magazine.

 

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Melita’s Inspirational Corner

Egg on Your Face

by Melita Hunt

 

I’m not going to talk about having Egg on Your Face in the traditional sense; because I believe that everyone has had embarrassing moments that they would prefer to forget and we don’t particularly want to  focus on those. Instead, I’m going to tell you about my moment of having egg on my face because I wanted to do it and it was a whole lot of fun….

Yesterday I was speaking to a friend about her daughter’s thirteenth birthday party which was two years ago. They had held a surprise summer Hawaiian “luau” for her and about 20 of her girlfriends (with little grass skirts and coconuts etc...) and she was reminiscing on how cute and fun it was.  She told me that this year they weren’t doing anything special for her birthday because she was turning 15 and was getting too old now for those “young themed parties.” 

Well I am one of those people who does not have the same belief system in regards to birthdays and parties. In fact, I probably have the opposite belief. I lead a very busy professional life so I absolutely love to take the time to have special birthdays, dress up and be involved in themed parties. My belief system espouses that if we were all willing to do silly things, let loose and laugh at ourselves more often (rather than worrying about what other people think) then this world would be a much lighter and happier place. And our kids wouldn’t think that it’s such a drag to be an adult…

So, I like to lead by example and last weekend I wore egg on my face and a chicken on my head all night. Read on:

It was one of my best friend’s 44th birthdays on Saturday night and I was the designated party organizer. Weeks ago we had joked about making it a “crazy hat” party for no particular reason and it just evolved from there. So I got on-line and bought over a hundred hats (did you know that there were companies that sell silly hats in bulk?). I also purchased an array of adornments so that people could make or decorate their own if they chose to do so. There were colored cowboy hats, accordion hats, animal print gangster hats, monster caps, hot dogs, crowns, tiaras and many more. The invitations went out and people were told that they had to be willing to wear a hat to be at the party.

We had all of our friends there (including professionals such as doctors, financiers, attorney’s, engineers and even traders) all willing to look really silly. Many of them brought their own hats, and the feather boa’s flowed. Everyone joined in the fun, swapping hats, making new ones and just laughing at one another. The night was a huge success and the atmosphere was electric.

One thing that I have learned time and time again is that if one person is willing to let their hair down and take the first step, then others will soon follow suit and that’s why I wore a chicken on my head and egg on my face all night. I hope you would be willing to do the same…

And before you ask the “question” about the chicken and the egg...here is the answer as far as I know (and read no further if you are offended by silly jokes…): 

The chicken was lying on the bed smoking a cigarette with a smile on his face and the egg was leaning up against the head board with her arms crossed saying: 

“Well I guess we know the answer to THAT question.”

Have a great week

Melita

 You can contact Melita at mel@iitm.com

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