4 Pitfalls in Investing in Commodity Options

Commodity options contracts allow a buyer and seller to reach an agreement to exchange goods at a set time in the future for a preset price. This can be a profitable way to invest if the buyer or seller can accurately predict changes in the price of the commodity in the future. The obvious pitfall in this strategy is guessing wrong and being held accountable to a trade that represents a loss.

#1 Unpredictability of Hard Commodity Pricing

Hard commodities, such as metals and natural resources, fluctuate in price on a daily basis. This can make a price very hard to accurately predict in the future. Of course, there is a wealth of data to use to estimate this price. However, data can be misinterpreted or even misleading. Even if the data is accurately assessed, there can be factors that come into play to change the price of a hard commodity. Oil is an excellent example. The oil market is heavily motivated by politics and cultural battles. As a result, even the best analyst can fail to predict an outlier in the market such as a war in an oil-producing country.

#2 Uncertainty of Soft Commodity Pricing

If hard commodity prices are difficult to predict, soft commodity prices are even more uncertain. With a soft commodity, such as grain or corn, spoilage, inclement climate and other factors are always a concern. Many analysts attempt to pay attention to this information, aggregating it to make predictions on prices. Many of them succeed. Outlying events, though, continue to be a huge concern. For example, in 2009, a deep freeze took hold in Florida's orange growing region for the first time in decades. This meant the price of oranges took an unpredictable climb. No analyst could have anticipated this result.

#3 Failing to Close the Contract

While there are obvious pitfalls in options markets when a trader misjudges future prices, there are pitfalls on the other end as well. When a trader is successful, he or she can react like a blackjack player at a hot card table. It is all too common to hear commodities traders express the sentiment, "I should have quit while I was ahead." The type of personality it takes to be a successful options trader means most of these traders like to take risks, make large bets, and let the cards fall. It can be hard for them to walk away while they are on top.

#4 Taking on Too Much Risk

When you invest in the commodity market, you have to be willing to lose and lose big. Investors unwilling to sustain losses will not last long with the unpredictable nature of the market. However, the most successful investors will know when risk is simply not worth the potential rewards. There is a curve in trading called the efficiency curve, and it represents how much additional risk must be taken on to improve returns by a given number. Once a trader approaches a high level of reward, taking the next step is taking on an exponentially higher amount of risk. Some do not know where to stop.

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