UV Market Blogs

Saturday, November 04, 2006

Leveraging commodities with stocks

Leveraging commodities with stocks

Commodities are best defined as “An article of trade or commerce, especially an agricultural or mining product that can be processed and resold.” In this case I mean gold, silver, corn, beef, whatever is traded on US commodity markets.

The problem with commodities is that they are not traded as freely as stocks are and because of high minimums they are traded mostly by institutional investors and other professional investors.  Commodity futures are often traded in 100,000 bushel lots, so for corn, this would require more than $200,000.  Commodities are less leveraged than the foreign exchange markets and opening a futures account usually requires huge minimums so I will show you a way to profit on the rise and fall of commodity prices.

Commodity prices are set on markets all around the world, but the biggest market is the Chicago Board of Trade Futures market.  Futures work by agreeing to purchase a commodity for a certain price on a certain date.  When buying futures, an investor believes that the value of the commodity will be higher when you take delivery, allowing the investor to make an instant profit on the investment.

Gold and Silver futures make up most of the activity on the futures boards.  Banks and governments alike turn to gold and silver bullion in order to protect their assets.

Since futures accounts require high minimum investments and also include numerous fees, trading certain stocks will allow an investor to invest in commodities by proxy without opening new brokerage accounts.

The best way to make a leveraged investment on gold is to buy stock in a company that is currently out of commission due to low gold prices.  There are many gold mining companies where it costs them $500 an ounce to mine and haven’t been able to until recently after gold prices surged.

A gold company that operates at a cost of $300 an ounce will not go up as high when gold prices go up as a company that operates at a $500 cost.  A $20 rise in gold will mean a much higher operating margin for the company that operates closest to current price in gold.  If gold is $550 an ounce and a company operates at $500 per ounce then a $20 rise in gold would mean that profits rise 40% for the company. 

News is a big player in commodities because of the supply and demand variables.  Stocks usually have no real demand and a steady supply.  Commodities are always in demand because they are used up and supply depends on how much is produced.  There is never a set supply for ANY commodity.  Bad weather could mean that corn yields are down 10%.

Sticker shock and stock splits

Sticker shock and stock splits

Sticker shock is an amazing phenomenon that continues to baffle me.  Why people are willing to pay $.99 for 6 eggs but not $1.29 for 12 makes me wonder about modern society.

A more likely example:
The increase in gas prices has left people “in a tizzy.” An increase of five cents a gallon will send people into chaos while when their cell phone bills go over $50 the same people don’t seem to have a care in the world.

A recent prize drawing for $100 at a certain local bank generated no interest.  Its $100, you’re in a bank where you probably have several times more stored away.  I mean, its just $100 right?

A very similar, just as advertised give-a-way is announced where winners will receive a $100 gas card.  Whoa, $100 in GAS?  That’s awesome, in the US that is about 40 gallons.  Everyone and their brother’s dog is there to sign up for the chance to win $100 (in free gas.)

Another thing, the American Express gift cards that can be spent ANYWHERE where American Express is taken, which for the most part, is everywhere.  Believe it or not, currency can be spent anywhere within the country or continent (euro) it is representing.  An American Express card is seen as such a great alternative to giving cash, even though in reality it is the same thing.

The gas card was effectively worth less than the $100 cash because cash has the potential to be spent on other necessities.  Gas can only be used by a small range of things.  But since the price of gas is relatively high, the gas card looked better than cash even though cash has more utility.

What does this have to do with the markets?

Stock splits happen all the time.  Usually stock splits are meant to increase the amount of shares and proportionately revalue the price of each share.  Reverse splits also occur which do the exact opposite, lower the amount of shares and raise the price.

Stock splits allow investors the chance to get involved in a company with less money than usually required.  (Most brokerages will not allow you to buy portions of shares, although some discount online brokers offer this service).

A stock priced at $100 is pretty expensive relative to the price of other stocks in the US.  If the stock was split 4 for 1, the stock price would drop to $25 per share and everyone would own four times as many shares.  Basically, nothing happens, you still have the same amount of money.

After stock splits however, investors tend to look at the stock more.  For one reason or another it seems as though after every stock split the stock rises several percentage points.  Stock splits seem to renew interest in the shares and send prices soaring.

Reverse splits do the exact opposite.  Usually reverse splits only occur because the company has to keep a minimum share price in order to stay on a certain exchange.  Many stocks on the AMEX stock exchange have to do this because the AMEX requires that stocks have a value of $1 per share.  If any less than $1 the company can be booted off the exchange.

After a reverse split goes through, the price of the new shares always drops.  Just like a normal split, the stock price is affected by renewed interest/disinterest in the stock.

Pricing has a huge effect on the overall markets.  Watch what happens after your favorite stock splits.  I would bet that in the few weeks following the split the stock will have risen a considerable amount, usually a few percentage points.