For full disclosure, our firm is not approved to trade futures for its clients. The following is a general discussion of the commodity futures market. Before investing in futures which can carry substantial risk, one should consult a commodity trading advisor registered with the National Futures Association.
Question #1: Why do Wall Street banks play such a large role in the commodity futures market yet they do not recommend they play a role in your investment portfolio?
Question #2: If you were a Wall Street banker and you knew of an investment that offered significant opportunity for gains but the opportunity was finite, would you try to protect this trade from others?
On this page, we'll explain the opportunity in the commodity futures market, why Wall Street seeks to protect this market for their own gains and why investors should be considering it.
First, let's examine the profit opportunity in trading commodity futures.
John Meynard Keynes theorized nearly a hundred years ago that the long-speculator in the commodity futures would enjoy profits from "running risks". Essentially, he believed that long-speculators were assuming risk from the commodity producers and in order to entice the speculalor, the market must provide him or her a price advantage. This price advantage is analagous to the risk premium. Wall Street firms play the role of the long-speculator, as does our strategy. We are simply copying what the big firms have done for decades.
Many years after Keynes and just a few years ago, two economists from Yale University sought to prove whether Keynes was correct or not. We have a page dedicated to their finding which you can read by clicking on this link: Facts and Fantasies about Commodity Futures. For the sake of this page, I'll just show you a picture from their study that is worth far more than "a thousand words".
What this chart, which is from the Yale Study, shows that over the span of the study, the returns of a long position in futures outperformed the change in spot price by a factor of nearly 3:1. This means a $1 gain in the spot would equate to a $3 gain in the futures position. The excess gain over spot amounts to the premium the producer pays to the speculator.
I think we can all agree that insurance companies make money. Why else be in insurance, right? According to Keynes and the Yale Study, playing the role of long-speculator in the futures market is essentially acting as an insurance company - assuming someone else's risk in return for a premium. Unlike many insurance products, futures do not have a broken out line item for "cost of insurance". The premium is intriniscally built into the contract.