Speculative Risk and Commodities Investments

By Amine Bouchentouf

Similar to the bond or stock markets, the commodities are populated by traders whose primary interest is making short-term profits by speculating whether the price of a security will go up or down.

Unlike commercial users who are using the markets for hedging purposes, speculators are simply interested in making profits; thus, they tend to move the markets in different ways. Although speculators provide much-needed liquidity to the markets (particularly in commodity futures markets), they tend to increase market volatility, especially when they begin exhibiting what former Federal Reserve Chairman Alan Greenspan termed “irrational exuberance.”

Because speculators can get out of control, as they did during the dotcom bubble, you need to always be aware of the amount of speculative activity going on in the markets. The amount of speculative money involved in commodity markets is in constant flux, but as a general rule, most commodity futures markets consist of about 75 percent commercial users and 25 percent speculators.

Too much speculative money coming into the commodities markets can have detrimental effects. At times, speculators will drive the prices of commodities beyond the fundamentals. If you see too much speculative activity, it’s probably a good idea to simply get out of the markets.

If you trade commodities, constantly check the pulse of the markets; find out as much as possible about who the market participants are so that you can distinguish between the commercial users and the speculators. One resource I recommend is the Commitment of Traders report, put out by the Commodity Futures Trading Commission (CFTC). This report gives you a detailed look at the market participants.