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Risks with Commodity MLPs

An Introduction to Commodities Futures Markets

In the futures markets, individuals, institutions, and sometimes governments transact with each other in commodities for price-hedging and speculating purposes, trying to make (or save) money.

An airline company, for instance, may want to use futures to enter into an agreement with a fuel company to buy a fixed amount of jet fuel for a fixed price for a fixed period of time. This transaction in the futures markets allows the airline to hedge against the volatility associated with the price of jet fuel.

Although commercial users are the main players in the futures arena, traders and investors also use the futures market to profit from price volatility through various trading techniques.

One such trading technique is arbitrage, which takes advantage of price discrepancies between different futures markets. For example, in an arbitrage trade, you purchase and sell the crude oil futures contract simultaneously in different trading venues, for the purpose of capturing price discrepancies between these venues.

The futures markets are administered by the various commodity exchanges, such as the Chicago Mercantile Exchange (CME) and the Intercontinental Exchange (ICE).

Investing through the futures markets requires a good understanding of futures contracts, options on futures, forwards, spreads, and other derivative products.

The most direct way of investing in the futures markets is to open an account with a futures commission merchant (FCM). The FCM is much like a traditional stock brokerage house (such as Schwab, Fidelity, or Merrill Lynch), except that it’s allowed to offer products that trade on the futures markets. Here are some other ways to get involved in futures:

  • Commodity trading advisor (CTA): The CTA is an individual or company licensed to trade futures contracts on your behalf.

  • Commodity pool operator (CPO): The CPO is similar to a CTA, except that the CPO can manage the funds of multiple clients under one account. This pooling provides additional leverage when trading futures.

  • Commodity indexes: A commodity index is a benchmark, similar to the Dow Jones Industrial Average or the S&P 500, that tracks a basket of the most liquid commodities. You can track the performance of a commodity index, which allows you to essentially “buy the market.” A number of commodity indexes are available, including the Goldman Sachs Commodity Index and the Reuters/Jefferies CRB Index.

These examples are only a few ways to access the futures markets.

A number of organizations regulate the futures markets, including the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC). These organizations monitor the markets to prevent market fraud and manipulation and to protect investors from such activity.

Trading futures isn’t for everyone. Futures markets, contracts, and products are extremely complex and require a great deal of mastery by even the best investors. If you don’t feel that you have a good handle on all the concepts involved in trading futures, don’t simply jump into futures — you could lose a lot more than your principal.

If you’re not comfortable trading futures, don’t sweat it. You can invest in commodities in multiple other ways.

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