Commodities have become an attractive investment in recent years, even for those who may not know much about them but would like to participate in the profit potential from dramatic price advances posted by energy, grains, metals and other commodities, lifting them to the highest overall levels in more than 30 years.

Fundamental factors based on simple supply and demand account for much of increased price activity, of course, but other factors are behind these price moves as well – factors you should understand if you are one those investors thinking about putting some of your money into commodities. Although commodities are a hot topic for investors, it is also an area where newcomers can get stung if they are not aware of some pitfalls that can trap the unwary.

So let’s first look at some of the factors promoting this increased interest in commodities and then, if you are interested in trying to tap profit opportunities in this area, at some instruments you can use to exploit this possibility.

Getting ‘real’

You are probably well aware of the “dot.com bubble” that took stock market indexes to record-high levels in the late 1990s into early 2000. The stock market was the place to be for many investors, evident by the growing amount of money that poured into mutual funds, 401(k)s and other investments tied to the value of stocks. Investors enjoyed the run of a bull market since 1982 as they focused on investments in paper instruments rather than physical products.

As with most meteoric rises, however, the accelerated rise in stock prices at the end of the 1990s couldn’t last forever and they began to fade. Then came the Twin Towers disaster on Sept. 11, 2001, the followup U.S. war on terror marked by armed incursions into Afghanistan and Iraq, accounting and other corporate fraud scandals (Enron, Worldcomm, et. al.) and a slowdown in global economies, all of which contributed to a decline in stock indexes, especially those reflecting technology stocks.

Many investors became disenchanted with prospects in stocks and began to look elsewhere to place their funds. Some put their money into housing and other real estate investments, causing a building boom and rapidly escalating property prices. China’s economic growth of more than 9% annually and the rebuilding required after two devastating hurricane seasons in a row along the Gulf Coast added to the huge demand for cement, copper and other building materials of all types (for more on the economic effect of hurricanes, see www.hurricaneomics.com).

Oil’s key role

Adding to the expanding worldwide demand for commodities, the ongoing war on terrorism re-emphasizes U.S. vulnerability to disruptions in oil supplies from the volatile Middle East, and prices skyrocketed above $80 per barrel in 2006. The higher oil prices get, the more attractive alternate energy sources look. The favorite alternative that has emerged from the pack is ethanol, produced primarily from corn.

With a big boost from Congressional mandates for ethanol production and usage, prices for corn began to shoot up last fall to the highest levels in more than 10 years, topping $4 a bushel after years of being closer to $2. Ethanol became the buzz word of the day, reinforced by President Bush’s comments about energy in his State of the Union message. When the government is pushing something, it’s best to trade in line with the government’s wishes, as interest rate traders know from watching actions of the Federal Reserve.

As demand for corn for ethanol grows, the higher corn prices may be driven and the more likely farmers will plant more corn at the expense of crops such as soybeans and wheat as crops compete economically for acreage. Livestock and poultry producers will also feel the effect of higher corn prices as will America’s grocery shoppers when they go to the meat counter.

With what some describe as a “housing bubble” cooling and investments in stocks still not having overwhelming appeal, investors have turned to where the hottest action is – real things like commodities. Commodities have particularly become the darlings of a rapidly proliferating number of hedge funds, which can trade anything, adding further fuel to the general advance in commodity prices.

Ready or not . . .

Some commodities have backed off from their price peaks, leading some to believe that a “commodity bubble” may be breaking just like the bubbles in stocks and housing. Never has an understanding of intermarket relationships been more important to traders as the domino effect of commodity price moves extends throughout a number of commodities.

Where prices of commodities now stand in the overall economic scenario is just one of the issues investors have to face today. With all the media buzz, is there still time to jump on the commodities bandwagon? If so, should you venture into futures or options based on commodities or get into one of the new commodity-based hedge funds or exchange-traded funds (ETFs) or invest only in stocks of companies involved in raw commodities?

Commodity futures trading involves an agreement by an investor to purchase or sell a specific amount of a commodity for delivery at a specific time in the future. The key points are the price at which you initiate a trade and the time that is left until the contract expires, at which time both parties are obligated to fulfill the terms of the contract unless they have offset or liquidated their position. If you think prices will rise before the contract expires, you buy or go long. If you think prices will fall from the current level, you can sell or go short as easily as you can buy.

ETFs are set up to achieve the same general return as an index – for example, the Spyders (SPY) ETF invests in all the stocks contained in the S&P 500 Index to mimic the results of the index. Commodity-based ETFs can invest in commodities directly through futures or in stocks from a sector influenced by what happens in commodities – a gold ETF based on a basket of gold mining stocks, for example. The advantages of ETFs are that they trade like a stock, don’t have the high leverage or risk that futures do and can diversify into a number of commodities or stocks that can dilute the effect of adverse moves in one commodity or stock.

Like any development that capitalizes on the hottest new trend, new ETFs are being offered every day. You have lots of choices so sift through them carefully. Some ETFs may be thinly traded so you need to understand what this investment can do before getting into it.

The commodities-related investment that may be most familiar – and, therefore, most prudent – for many investors involves investing in those companies that are most influenced by prices of commodities. If you think prices of copper will go up, for example, buy those stocks that would benefit most from higher copper prices. Ditto for oil prices or grain prices. Again, you have a number of choices so you will have to do your research to see which prices will mean the most to which companies.

Futures pros and cons

Of the various choices, futures are the most direct play on price movement – and usually carry the most risk. The major lure of trading futures is the ability to make a large amount of money in a short time with a relatively small down payment. For example, to trade a 5,000-bushel contract of corn worth $20,000 with corn priced at $4 a bushel, the Chicago Board of Trade currently requires a minimum margin or good-faith deposit of $1,350 – less than 7% of the value of the contract. If you invest in stocks, you have to put up at least 50% of the value of the shares.

Every 1-cent change in the price of corn amounts to a $50 change in the value of a corn futures contract. If you buy corn futures and the price goes up 20 cents, your profit is $1,000. That’s a gain of nearly 75% on your initial margin of $1,350! And a 20-cent move in corn prices in today’s market conditions is very possible, sometimes in just one day. No wonder futures trading is so attractive to investors looking at commodities compared to other investment areas.

But beware. There is another side of the corn that a newcomer to futures needs to recognize before becoming involved in this type of trading. While the futures market can boost your account quickly, it can also diminish your account just as quickly. Commodities are generally much more volatile than stocks, making them a rough-and-tumble marketplace for the inexperienced.

Timing is a critical factor in trading futures. In fact, you can be right about the direction of prices but wrong about the timing of the move and lose a significant amount of money. That’s true in any market but is compounded in futures due to the larger increments and high leverage involved in futures. Even a relatively small adverse price move against your position can deal a big blow to your trading account.

Still, for those who can tolerate the risk, the possibility of large profits has an obvious appeal for investors seeking more action for their investment money. If you do decide to trade futures, you can improve your odds for success by first learning about and understanding how futures markets operate, then getting reliable information about markets and what is moving them from sources such as TradingEducation.com, a free educational web site.