Introduction to Commodities Investing

Module 2: Speak the Language of Commodities Investing

Bonus: Definitions of the Most Important Commodities Investing Words and Terms

• Aggregators: Parties that purchase mortgages from financial institutions and then securitise them back into mortgage-backed securities for investment by the general public.

• Alpha: A performance indicator based on risk-adjusted factors. Generally, alpha refers to the outperformance/underperformance of a security compared to a broad benchmark such as the S&P 500.

• American-Style: Said of an option contract that can be exercised at any time up to the option’s expiration date.

• Arbitrage: The process by which a particular asset is both purchased and sold at the same time in order to profit from the difference in price.

• Ask Price: The price that a seller is willing to accept for a particular security.

• Ask Size: The amount of shares of an individual security that a seller is offering at the ask price.

• Assets Under Management: The total value of a fund’s assets.

• At the Money: An option in which the underlying’s price equals the exercise price.

• Authorised Participant: An entity chosen by an exchange-traded product that is responsible for providing the underlying assets necessary to create an ETF.

• Average Volume: The average number of shares traded daily.

• Backwardation: The process whereby near-month futures are more expensive than those expiring farther into the future, creating a downward sloping curve for futures prices over time. People or institutes are willing to sell in the future at a discount to the expected price because of volatility.

• Beta: A measure of volatility, or systematic risk, in comparison to a particular market as a whole.

• Bid Price: The price that a buyer is willing to pay for a particular security.

• Bid Size: The amount of shares of an individual security that a buyer is willing to buy at the bid price.

• Blend: A fund of securities that have both growth and value characteristics.

• Bourse: A stock market in a non-English speaking country.

• Call Option (Call): An option that gives the holder the right to buy an underlying asset from another party at a fixed price over a specific period of time.

• Carrying Costs: The cost of storing inventory, such as crude oil and gold bullion.

• Carryout: Perhaps the most important number issued in crop production reports. Carryout is the amount of grain left over after all demand has been satisfied. Essentially, carryout equals supply minus demand. (Also known as Ending Stocks.)

• Cash Commodity: A tangible product to be delivered in exchange for payment and is seen most frequently with futures options. A contract for a cash commodity will specify the exact amount of the commodity that is expected to be delivered, along with the delivery date and the price.

• Clearing: The process by which the exchange verifies the execution of a transaction and records the participants’ identities.

• Collectible: An asset that is worth far more than its intrinsic appears due to its rarity or an overwhelming demand for the particular item.

• Commodity Futures Trading Commission: A U.S. federal agency put into place by the Commodity Futures Trading Commission Act of 1974. The entity is made up of five commissioners who ensure fair and efficient open market trades.

• Commodity Pool Operator (CPO): Persons or limited partnerships responsible for investing a commodity pool’s assets in commodity-futures and options positions. Commodity pool operators solicit funds for trading in securities such as futures contracts, or off-exchange foreign exchange contracts.

• Commodity: A commodity is a raw material or primary agricultural product used in commerce. They are interchangeable with commodities of the same type.

• Contango: The process whereby near-month futures are cheaper than those expiring farther into the future, creating an upward sloping curve for future prices over time. People or institutes are willing to pay more to buy a commodity in the future than the actual expected price of that commodity.

• Convergence Trades: A process which occurs when the price of a futures contract moves towards the price of the underlying commodity upon the expiration of the specific contract.

• Correlation: In investing, correlation is a statistic that measures the degree to which two securities move in relation to each other.

• Credit Risk: The risk of the loss of principal based on the borrower’s inability to repay a debt.

• Currency ETF: A product that tracks a particular currency or currencies through the exchange-traded structure.

• Currency Pair: A currency pair is the quotation and pricing structure of the currencies traded in the forex market; the value of a currency is a rate and is determined by its comparison to another currency.

• Currency Risk: The risk of the change in value of one currency against another.

• Derivative: A financial instrument/contract whose value depends on the value some underlying asset or factor.

• Discount Broker: A stockbroker who carries out buy and sell orders at a reduced commission rate. However, unlike with a full-service broker, no investment advice is provided by a discount broker.

• Discount: This occurs when the underlying holdings of an ETF are trading for less than their net asset value.

• Dividend: A distribution of a company’s profits to its shareholders.

• Drawdown: A drawdown is the peak-trough decline during a specific recorded period of an investment, fund, or commodity. A drawdown is usually quoted as the percentage between the peak and the subsequent trough. Those tracking the entity measure from the time a retrenchment begins to when it reaches a new high.

• ECB: European Central Bank

• E-Mini: An electronically traded futures contract on the Chicago Mercantile Exchange that represents a portion of the normal futures contracts. E-mini contracts are available on a wide range of indexes such as the Nasdaq 100, S&P 500, S&P MidCap 400 and Russell 2000.

• Equal Weighted: This refers to an indexing methodology that typically equally weights individual securities in a particular fund. It may also refer to the equal weighting of sectors, countries, and other factors built into exchange traded products.

• ETF: An exchange-traded product that is bought and sold on an intraday securities exchange and is composed of a basket of securities. Generally, ETFs will trade at (or very close to) the same price as the net asset value of the underlying assets.

• ETN: Exchange-traded notes are debt instruments that are linked to an underlying index. Whereas most debt securities make regular interest payments at a fixed or floating rate, ETNs make a cash payment at maturity based on the performance of the underlying benchmark (less management fees). If the underlying index increases in value, the cash payment at maturity will be greater than face value. But if the benchmark declines, it’s possible that the return of principal will be less than the initial investment.

• European-Style: Said of an option contract that can only be exercised on the option’s expiration date.

• Exchange-Traded Product: A fund that is linked to a particular index allowing investors to hold a basket of securities by investing in a single ticker. (Also known as an Exchange Traded Vehicle.)

• Exemptive Relief: Several key characteristics of ETFs are not consistent with the U.S. Investment Company Act of 1940. Therefore, in order for an ETF to be created, it must first file for relief from some of the provisions outlined by this piece of legislation.

• Exercise Price: The fixed price at which an option holder can buy or sell the underlying. (Also known as the Strike Price, Striking Price, or Strike.)

• Expense Ratio: A measure of the costs necessary to operate a particular fund. These expenses are taken out of the fund’s assets and cut into investors’ returns.

• Fair Value of a Futures Contract: The price of the contract at which a buyer of the stock would be neutral between buying the actual stock on a stock exchange and buying a futures contract.

• Fixed-for-Floating Interest Rate Swap: An interest rate swap in which one party pays a fixed rate and the other pays a floating rate, with both sets of payments in the same currency. (Also known as a Plain Vanilla Swap or Vanilla Swap.)

• Forex: Forex (FX) is the market in which currencies are traded. The forex market is the largest, most liquid market in the world, with average traded values that can be trillions of dollars per day. It includes all the currencies in the world.

• Forward Contract: An over-the-counter derivative contract in which two parties agree that one party, the buyer, will purchase an underlying asset from the other party, the seller, at a later date at a fixed price they agree on when the contract is signed.

• Fund of Funds: A product that invests in other funds at the individual security level, instead of selecting stocks and bonds.

• Futures Contract: A standardised derivative contract created and traded on a futures exchange in which two parties agree that one party, the buyer, will purchase an underlying asset from the other party, the seller, at a later date at a price agreed upon by the two parties when the contract is initiated and in which there is a daily settling of gains and losses and a credit guarantee by the futures exchange through its clearinghouse.

• Futures-Based: A product which allocates to futures contracts of a particular security or a basket of securities, which are most often found in the commodity space.

• Growth: These are companies that have high P/E multiples with low to even no dividend distribution, but their upside comes from the fact that they are expected to grow at a strong pace. ETFs exhibiting growth strategies will allocate to these kinds of companies for their individual securities.

• Hard Commodity: Hard commodities are typically natural resources that must be mined or extracted, such as gold and oil.

• Hedge: A hedge is an investment made to reduce the risk of adverse price movements in an asset. This usually involves taking an offsetting position in a related security.

• In the Money: Options that, if exercised, would result in the value received being worth more than the payment required to exercise.

• Index Fund: An index fund is a type of mutual fund with a portfolio constructed to match or track the components of a market index, such as the S&P 500 Index. An index mutual fund is said to provide broad market exposure, low operating expenses, and low portfolio turnover. These funds adhere to specific rules or standards that stay in place no matter the state of the markets.

• Index: An index is an indicator or measure of something, and in finance, it typically refers to a statistical measure of change in a securities market. In the case of financial markets, stock and bond market indices consist of a hypothetical portfolio of securities representing a particular market or segment of it. (You cannot invest directly in an index.) The S&P 500 and the US Aggregate Bond Index are common benchmarks for the American stock and bond markets, respectively.

• Inflation: The rate at which the general level of prices of goods and services are rising; and, consequently, the rate at which the purchasing power of the relevant currency is falling.

• Initial Margin: The amount that must be deposited in a clearinghouse account when entering into a futures contract.

• Inverse ETFs: ETFs which short-sell their respective indexes. They can also be combined with leverage.

• Investment Companies: Companies whose business derives from investing assets in various funds and securities to return a profit.

• Investment Company Act of 1940: An act of U.S. Congress which defines the responsibilities and limitations that guide companies that offer investment products to the general public.

• ISM Manufacturing Index: The ISM Manufacturing Index is based on surveys of more than 300 manufacturing firms by the Institute for Supply Management (ISM). The ISM Manufacturing Index monitors employment, production, inventories, new orders, and supplier deliveries.

• Large Cap: In the U.S., a company whose market capitalisation is greater than $10 billion.

• Lead Market Maker (LMM): The first or most significant broker-dealer firm that holds a certain number of shares of a particular security or asset in order to facilitate the trading in that security.

• Leverage: Leverage is the investment strategy of using borrowed money; specifically, the use of various financial instruments or borrowed capital to increase the potential return of an investment. Leverage can also refer to the amount of debt used to finance assets. When one refers to something (a company, a property, or an investment) as “highly leveraged”, it means that the item has more debt than equity.

• Limit Down: A limit move in the futures market in which the price at which a transaction would be made is at or below the lower limit.

• Limit Order: An order placed with a brokerage firm to buy or sell a certain number of shares at a fixed price or better. Investors can set a time limit on a limit order, allowing it to remain outstanding for a set period of time before it is either acted upon or cancelled.

• Limit Up: A limit move in the futures market in which the price at which a transaction would be made is at or above the upper limit.

• Limited Partnership (LP): An LP exists when two or more partners unite to jointly conduct a business in which one or more of the partners is liable only to the extent of the amount of money that partner has invested. Limited partners do not receive dividends, but enjoy direct access to the flow of income and expenses. The main advantage to this structure is that the owners are typically not liable for the debts of the company. (Also known as a Limited Liability Partnership (LLP).)

• Liquidity Provider: A market maker that holds a sizeable number of shares of a certain security in order to facilitate the trading of that security.

• Locked Limit: A condition in the futures markets in which a transaction cannot take place because the price would be beyond the limits.

• Maintenance Margin: The minimum amount of equity that must be maintained in a margin account. In the context of the NYSE and FINRA, after an investor has bought securities on margin, the minimum required level of margin is 25% of the total market value of the securities in the margin account. Keep in mind that this level is the minimum, and many brokerages have higher maintenance requirements of 30-40%. (Also known as Minimum Maintenance or Maintenance Required.)

• Margin Call: A margin call is a broker’s demand on an investor using margin to deposit additional money or securities so the margin account is brought up to the minimum maintenance margin. Margin calls occur when the account value depresses to a value calculated by the broker’s particular formula.

• Margin vs. Leverage: Although interconnected – since both involve borrowing – leverage and margin are not the same. Leverage refers to the act of taking on debt. Margin is a form of debt or borrowed money that is used to invest in other financial instruments. A margin account allows you to borrow money from a broker for a fixed interest rate to purchase securities, options, or futures contracts in the anticipation of receiving substantially high returns. In short, you can use margin to create leverage.

• Market Cap: The total value of the outstanding shares of a particular company.

• Market Depth: The measure of the number of buy and sell orders for a particular security.

• Market Value-Weighted Index: A type of market index with individual components that are weighted according to their total market capitalisation. The larger components carry higher percentage weightings, while the smaller components in the index have lower weights. (Also known as a Capitalisation-Weighted Index.)

• Mark-to-Market: The revaluation of a financial asset or liability to its current market value or fair value.

• Micro Cap: In the U.S., a company whose market capitalisation is between $50 million and $300 million.

• Mid Cap: In the U.S., a company whose market capitalisation is between $2 billion and $10 billion.

• Mutual Fund: A mutual fund is an investment vehicle made up of a pool of money collected from many investors for the purpose of investing in securities such as stocks, bonds, money market instruments, and other assets. Mutual funds are operated by professional money managers, who allocate the fund’s investments and attempt to produce capital gains and/or income for the fund’s investors. A mutual fund’s portfolio is structured and maintained to match the investment objectives stated in its prospectus.

• Net Asset Value (NAV): The price-per-share value of an exchange-traded product or mutual fund.

• Non-Deliverable Forwards (NDFs): Cash-settlement forward contracts, used predominantly with respect to foreign-exchange contracts. (Also known as Contracts for Differences.)

• Open Interest: The number of outstanding contracts in a clearinghouse at any given time. The open interest figure changes daily as some parties open up new positions, while other parties offset their old positions.

• Option Premium: The amount of money a buyer pays and seller receives to engage in an option transaction.

• Option: A derivative contract in which one party, the buyer, pays a sum of money to the other party, the seller or writer, and receives the right to either buy or sell an underlying asset at a fixed price either on a specific expiration date or at any time prior to the expiration date.

• Out of the Money: Options that, if exercised, would require the payment of more money than the value received and therefore would not be currently exercised.

• Over-the-Counter (OTC): OTC involves a security traded in some context other than on a formal exchange such as the New York Stock Exchange (NYSE). The phrase, “over the counter” can be used to refer to stocks that trade via a dealer network as opposed to on a centralised exchange. It also refers to debt securities and other financial instruments, such as derivatives, which are traded through a dealer network.

• P/E: The price-to-earnings is a valuation ratio of a company’s current share price in relation to its current earnings per share.

• Physical-Based: Physical-based products offer exposure by physically holding a particular commodity or basket of commodities.

• Pip: The smallest price move that a given exchange rate makes based on market convention. Since most major currency pairs are priced to four decimal places, the smallest change is that of the last decimal point; this is equivalent to 1/100 of 1%, or one basis point.

• Premium: This occurs when a fund is trading at a higher price than its net asset value. Premiums can also be applied in the fixed income space, when a particular bond is trading at a price above its par value.

• Price Limits: Limits imposed by a futures exchange on the price change that can occur from one day to the next.

• Prime Brokers: Brokers that provide services including custody, administration, lending, short borrowing, and trading.

• Principal: The original amount of money borrowed in a loan, or put into an investment.

• Producer Price Index (PPI): The PPI is a weighted index of prices measured at the wholesale, or producer level. The PPI shows trends within the wholesale markets, manufacturing industries, and commodities markets.

• Put Option (Put): An option that gives the holder the right to sell an underlying asset to another party at a fixed price over a specific period of time.

• Redemption: A redemption involves the return of an investor’s principal in a fixed-income security, such as a preferred stock or bond, or the sale of units in a mutual fund. Fixed income securities are redeemed at par value on the maturity date, and called bonds are redeemed at a premium price above par. Mutual fund investors redeem mutual fund shares. Some mutual funds have minimum holding periods and back-end sales charges.

• Risk-Adjusted Return: Risk-adjusted return refines an investment’s return by measuring how much risk is involved in producing that return, which is generally expressed as a number or rating. Some common risk measures include alpha, beta, R-squared, standard deviation, and the Sharpe ratio.

• Rollover: A rollover occurs when reinvesting funds from a mature security into a new issue of the same or a similar security, transferring the holdings of one retirement plan to another without suffering tax consequences, or moving a forex position to the following delivery date. The forex rollover fee arising from the difference in interest rates between the two currencies underlying a transaction is paid to the broker.

• Safe Haven: An investment that is expected to retain or increase in value during times or market turbulence.

• Securities and Exchange Commission (SEC): A U.S. federal agency which is responsible for enforcing federal securities laws and regulating the securities industry as a whole.

• Seed Capital: The initial capital and funding used to start a business or fund.

• Sentix Investor Confidence Report: The Sentix Investor Confidence report is a monthly gauge of current business conditions in the Eurozone. Conducted by the German market research firm Sentix, the Investor Confidence report is designed to evaluate the sentiment of investors as it pertains to the current and future performance of the economy.

• Settlement Price: The official price, designated by the clearinghouse, from which daily gains and losses will be determined and marked to market.

• Settlement: The process that occurs after a trade is completed, the securities are passed to the buyer, and payment is received by the seller.

• Small Cap: In the U.S., a company whose market capitalisation is between $300 million and $2 billion.

• Soft Commodity: Soft commodities, such as coffee, cocoa, sugar, corn, and wheat, are generally grown rather than mined.

• Stop Loss: An order placed to sell a security if it reaches a specified price.

• Swap: An over-the-counter derivative contract in which two parties agree to exchange a series of cash flows whereby one party pays a variable series that will be determined by an underlying asset or rate and the other party pays either (1) a variable series determined by a different underlying asset or rate or (2) a fixed series.

• Ticker Symbol: An arrangement of characters (usually letters) representing a particular security listed on an exchange or otherwise traded publically.

• Tracking Error: The divergence between the price behaviour of a position or a portfolio and the price behaviour of a benchmark.

• Trailing Stop: A trailing stop is a stop order that can be set at a defined percentage away from a security’s current market price. An investor places a trailing stop for a long position below the security’s current market price; for a short position, they set it above the current price. A trailing stop is designed to protect gains by enabling a trade to remain open and continue to profit as long as the price is moving in the investor’s favour but closes the trade if the price changes direction by a specified percentage. A trailing stop can also specify a currency amount instead of a percentage.

• UK Markit/CIPS Construction PMI: The UK Markit/Chartered Institute of Purchasing and Supply Purchasing Managers Index measures the performance of the construction sector and is derived from a survey of 170 construction companies.

• UNICA: Brazilian Sugarcane Industry Association

• Unit Investment Trust (UIT): An investment company that offers a fixed portfolio, generally of stocks and bonds, as redeemable units to investors for a specific period of time.

• Value: Value companies typically have low pricing multiples and are generally more mature companies with strong dividend pay-outs. ETFs exhibiting value strategies will allocate to these kinds of firms for their individual securities.

• Volatility: A statistical measure of the dispersion of returns for a given security or market index.

• Volume Weighted Average Price (VWAP): A trading benchmark used especially in pension plans. VWAP is calculated by adding up the currency value traded for every transaction (price multiplied by the number of shares traded) and then dividing by the total shares traded for the day. The theory is that if the price of a buy trade is lower than the VWAP, it is a good trade. The opposite is true if the price is higher than the VWAP.

• Volume: The number of shares traded during a given period of time.

• WASDE: World Agricultural Supply and Demand Estimates

• Year-to-Date (YTD): YTD performance is a measure of the gains or losses accumulated from the first trading day of the year to the present day.