The idea of utilizing commodity investing plus leverage can go either very well or very badly. Commodities are prone to wild speculation, as seen in 2007-2008 when oil prices hit $147 a barrel or with the infamous “Silver Thursday” of 1980, where two billionaires ended up getting hit with a margin call that even their resources could not cover, inspiring the movie “Trading Places” and becoming an infamous example of where utilizing leverage on a trade that fails can destroy even the most prudent trader.
Why use leverage on such a risk?
Investors will utilize leverage, or credit in other words in order to amplify their returns. Think of this like a credit card. If someone invests $100,000 for example and utilizes $50,000 of margin, there is a total of $150,000 in play. If he has a 100% return equaling $300,000 then using the margin makes sense. However if the investor loses everything, he is not only out of the original investment but also the lost margin balance.
Although brokerage firms and exchanges have a minimum margin requirement (cash on hand to cover a percentage of the margin being used) for securities it should be noted that greed will take over at some point, the investor being blinded by the potential returns versus real returns. A well disciplined trader with years of experience may even occasionally fall victim to human fallibility but more often than not investors motivated more by emotion than reason will not only fail to do their due diligence but make critical mistakes when executing the trade.
How can I avoid disaster…… on credit?
Playing the commodities trade is a very lucrative and very exciting segment of the financial markets. Those with the fortitude and foresight to make the best trades will walk away with riches far beyond their wild imaginations, however for every one tale of triumph there are a hundred of woe. But it should match ones’ style of investing and appetite for risk; therefore one should analyze their financial situation and make sure that this is the type of arena that one wants to enter. In addition before making a trade, one should do exhaustive due diligence and research before making any trade. Making sure that this is a prudent investment based on hours (and yes, hours; hedge funds and institutions employ armies of analysts working 15 hour days equipped with training and resources far beyond what Joe and Jane Investor can even begin to dream of mustering) of research will save tons of grief down the line.
If leverage is to be used, it should be done in increments and only when absolutely necessary, this is where dollar cost averaging (employing capital at different points, averaging out a specific amount in the long term) would come into play to keep risk to a minimum. In addition, one should not let their emotions get the best of them. Human beings are creatures of emotions and no amount of crying, expletives and praying to holy deities will reverse a trade going the wrong way. Keeping an entry and exit point, so that way initial capital and profits respectively will be protected is an excellent way to minimize risk in an already very risky market.