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Cheat Sheet

Commodities For Dummies

From Commodities For Dummies, 2nd Edition by Amine Bouchentouf

The major commodities exchanges trade specific commodities worldwide, and the main regulatory organizations provide information and enforce codes to protect commodities investors. When investing in commodities, use guidelines and advice from the experts to lower your risks.

Matching Commodities with Commodity Exchanges

The 20th century saw a proliferation of commodity exchanges around the world, with many based in the money centers of New York and Chicago. In the first decade of the 21st century, the industry experienced a major consolidation period — partly driven by electronic-based trading platforms — that dramatically reduced the number of players in the space and increased the product offerings of the remaining exchanges. Here are some of the important exchanges in today's new environment.

Commodities and Emerging Markets

One of the driving forces behind the dynamic commodities markets are emerging markets, both from the demand side and also in terms of supply. Keep an eye on Brazil and China, two countries that tend to move markets.

  • Brazil: A powerhouse in the commodities markets, Brazil has been blessed with an abundance of natural resources. It's one of the top agricultural countries in the world, with leading positions in coffee, cocoa, corn, wheat, eucalyptus, and sugar cane production. In energy, it has large reserves of crude oil in the offshore basins off the Atlantic Ocean. It also has sizable mining reserves with abundant iron ore resources. Since Brazil holds such a dominant position in the supply and production of key commodities, it's important to monitor this country very closely.

  • China: China has been the miracle story of the beginning of the 21st century. Many analysts compare its rise to the emergence of the United States as an economic powerhouse in the late 19th and early 20th centuries. Home to more than 1.3 billion citizens, China is a truly gigantic market. In many instances, it has been the main driving force behind demand increases for important commodities, including steel, copper, wheat, and crude oil. As the Chinese economy continues to expand at eye-popping rates (averaging 9 percent annually during the first decade of the 21st century), expect it to push demand for commodities at even more important levels.

Consulting Investment Regulatory Organizations

In the era after the 2008 Global Financial Crisis (GFC), the importance and responsibilities of market regulators have grown exponentially. The GFC exposed many deficiencies in the way markets and market participants operate, so frequently consulting with regulators has become a necessity for any risk-averse market participant. These organizations are some of the key regulatory bodies for commodities and other investments:

Growing Interest in Agricultural Commodities

Agricultural commodities are usually overshadowed by energy and metal commodities. Recently, however, investors have been eyeing agricultural commodities as traders become aware of the enormous importance of these commodities from both a market and investment perspective. Wheat shortages in 2009–2010 and the subsequent food riots they caused globally shone a spotlight on this segment of the market. The following are some important agricultural commodities, along with their corresponding exchanges:

  • Grains/cereals: Corn, oats, soybeans, wheat (Chicago Mercantile Exchange)

  • Meat products: Feeder cattle, lean hogs, live cattle, frozen pork bellies (Chicago Mercantile Exchange)

  • Tropical products: Coffee, cocoa, orange juice, sugar (Intercontinental Exchange)

Generating Risk-Adjusted Returns

Investing is all about managing risk, and here are two ways to approach risk management: (1) According to uber-investor Warren Buffet, Rule #1 of investing: Never lose money. Rule #2 of investing: Never forget rule #1; (2) If you focus on protecting your downside, the upside will take care of itself. Here are a few key risk variables you should be monitoring constantly:

  • Volatility: Volatility is the way that investors measure price variation and fluctuation of a given security over time. The higher the variation, the more volatility. For example, if a security trades at $5 on Monday, $15 on Tuesday, and $7 on Wednesday, it's exhibiting extreme volatility. If you're a novice investor, you should trade these types of securities with extreme care.

  • Standard deviation: Standard deviation is a statistical measure of the amount of volatility inherent in a security. The standard deviation formula is a complex one, but it's extremely powerful and practical. With one number, you can determine just how volatile a security or asset is. The higher the standard deviation, the riskier the asset; conversely a low standard deviation number means the security is more stable from a pricing perspective. A stable Fortune 500 company tends to have a lower standard deviation than a startup tech company. Use this powerful metric to help make better trading decisions.

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