Commodities: The New Tech Stocks?
The marketing pitches are increasingly common—in print, on television, and especially on the Internet. There's "Oil Speculators Trade Currency. You Can Too!" and "Online Commodity Traders: Free Tools, Better Futures Trading." Another proclaims: "Trade Futures for only $0.99!"
Commodities seem to have become the new tech stocks. The prices for oil, gold, corn, and other commodities have surged over the past year, resulting in outsize returns for a few savvy investors and large financial institutions. Now, the call is being sounded for individual investors to jump in the pool. Splashy ads trumpet everything from budget brokerage fees for commodities trading to foolproof trading systems. In December, the latest edition of Commodities for Dummies was published.
But experts warn that commodities trading is a dangerous game for the average individual investor, with high stakes and treacherous twists in price movements. "Commodities are a really great way to lose money," says David Wyss, chief economist for Standard & Poor's, which like BusinessWeek, is a unit of the McGraw-Hill Cos. (MHP). "You're better off playing poker in Vegas."
Stepping Up Enforcement
The Commodity Futures Trading Commission, which regulates the industry, is also warning investors to be careful. It has issued a number of advisories cautioning investors about the dangers of fraud and get-rich-quick schemes. This month, the commission put out a revised version of its advisory, "Beware of Web Sites Selling Commodity Trading Systems that Guarantee High Profits with Minimal Risks," which warns that futures contracts are risky and that what sounds too good to be true likely is. "Commodities are publicized more as an alternative now," says Paul Hayeck, associate director of the CFTC's enforcement division, "and there are people ready to take advantage of people who aren't educated about these markets. They'll misrepresent the whole thing to anyone willing to listen."
The CFTC Web site lists hundreds of enforcement actions against alleged fraudsters in the commodities and foreign exchange markets. In one recent case, a company called Castle Enterprises allegedly set up Web sites such as Never-Lose.com and WallStreetWar.com. The man the CFTC says was behind the sites, Gilbert Philip Castillo Jr., convinced potential clients that he was a successful commodities trader and adviser, able to deliver extraordinary returns on modest sums of cash, a government complaint alleges.
From 1999 to 2005, hopeful investors paid Castillo to advise them how to play the commodities game and to execute trades in futures and options. But Castillo had never registered with the CFTC as a Commodity Trading Advisor (CTA), as the commission's rules require. Earlier this month, the CFTC announced that a California court ordered Castillo and Castle Enterprises to return more than $800,000 to 125 investors whose hopes of big returns had left them with nothing.
Castillo failed to appear in court on Feb. 5 for a hearing on the case. His attorney says that his client could not be reached immediately for comment.
Leverage Can Be Lethal
Wyss says that the current push to persuade investors to put their money into commodities is similar to the marketing behind day-trading in the 1990s, when many small investors tried to trade stocks daily and ended up losing large sums of money. But he says the current trend could be even worse.
Trading commodities can be riskier than trading stocks for at least two reasons. First, there's more leverage. An investor who buys shares in AT&T (T) or IBM (IBM) usually pays 100% of the purchase price, and puts up 50% as a downpayment even if they're borrowing money from their brokerage firm. With commodities, investors can often put down as little as 5% of the value of a contract for oil or corn.
While the stock investor usually can only lose the money he pays for shares (or double if he's using leverage), the commodities investor can lose 20 times his money or even more.
The second reason commodities trading is risky is that there's no typical direction to the markets. The stock market tends to go up over time, though, of course, there are booms and busts. Not so with commodities, where prices depend on a complex nexus of supply and demand, from geopolitical events and the weather to speculation on daily news headlines and analysts' technical charts. A trader navigating this minefield needs a deep understanding of these dynamics because the competition can be cutthroat. "Commodities trading is a zero-sum game," says Wyss. "The only way you make money is to be smarter than the other guys doing it. Since they've been at it a long time, your odds aren't good."
Sophistication a Must
That's not to say investors should avoid commodities entirely. Wyss and others point out that large institutions and sophisticated investors include commodities in their portfolios, as long-term investments that can help boost returns and dampen overall volatility. Individual investors can use the products for the same purpose if they're careful and take a long-term perspective. Short-term commodities trading and speculation are the most dangerous.
GoFutures is the company that's currently advertising on the Internet for 99¢ trades. When investors trade oil or other commodities, they're typically trading not the product itself, but rather futures or options contracts on the product. A futures contract is an agreement to buy or sell a product at a particular price sometime in the future, while an options contract is the right, but not the obligation, to buy or sell a product for a fixed price at some point in the future.
Alex Tayebi, senior vice-president of San Jose (Calif.)-based GoFutures, says that "the whole 99¢ thing is pretty catchy." Roughly 75% of his clients are self-directed commodities traders and the remaining 25% are advised by brokers at his firm. With a minimum investment of $2,000, an investor can get started on his or her own commodities account with GoFutures, which recommends a minimum of two to three years of trading equities and one year trading futures.
Tayebi says that his clients are both "new guys" and "pros." Most of the self-directed clients are the "new guys" who are less experienced in futures, and Tayebi himself says he doesn't think commodities are for the ill-prepared. "I don't recommend it to rookies," Tayebi says. For those who come to his company without much experience, GoFutures assigns an adviser to keep watch and assist if necessary. But he says that in the end self-directed customers make their own decisions.
Ads for dozens more companies appear when the search terms "commodities trading" are entered in a search engine. Like GoFutures, RJO Futures markets to prospective clients using Google (GOOG) ad search as well as print, television, and direct mail marketing. The Chicago firm, a division of R.J. O'Brien, a 93 year-old futures trading company, offers free information about commodities on its Web site and a variety of options for clients from self-directed to advised and fully brokered accounts. A minimum of $5,000 is required to trade futures.
About a quarter of the company's self-directed clients are newcomers to commodities, says marketing director Guy Swartz. He says that he believes it is possible for retail investors to benefit from the volatility of commodities—as long as they understand that the stakes are high. "I believe there is a way for the retail person [individual investor] to enter into this market at a pace that can provide possible success," says Swartz. "It's true that the volatility here is extreme, and there's a huge learning curve here. Education and hand-holding as a new investor gets his or her wings is the proper way to bring someone in."
"Potentially Large Losses" Loom
Douglas Carper isn't convinced. He's a veteran commodities trader with more than 30 years under his belt who now runs DEC Capital in Lincoln, Neb. He's posted some glitzy returns for his investors, including a stretch last year where he doubled their money by betting that corn prices would rise. But he says newcomers stand little chance of profiting from commodities and could lose much more than they expect.
"Most people are likely to gloss over fine print and plunge right in," says Carper. "It's a lot of potentially large losses to people without capacity to absorb risk—and far greater losses to accept than they ever expect."
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