One of my favorite writers and lecturers (and Byron’s, too) is James Howard Kunstler. The Long Emergency is the title of one of Kunstler’s books, as well as one of his catchphrases, and, boy, is it dead on.

This commodities frenzy, and the related dash by nations to snatch up and secure all sorts of resources, has been a long time coming. It certainly didn’t happen overnight. I can safely say that for the vast majority of my career, commodities have been the poor red-headed stepchildren of the investment world. Two decades ago, when I walked onto the trading floor of the New York Cotton Exchange at the old World Trade Center, the climate was very different from today’s.

Back then, most “mainstream” investment houses looked at the commodity markets as a subculture. Commodities were, basically, another branch of Las Vegas, just without the free buffets, dancing girls and booze. Actually, maybe some of that stuff was available on a daily basis, but it was a lot different then.

I compare it to how Times Square was back in the 1970s and early ’80s. If you ever visited the Big Apple back then, you know that Times Square was the worst of all things. It was a seedy, grimy, crime center filled with many colorful characters. Let’s just say Times Square was not a place tourists went, unless, of course, they were sex tourists.

Beneath it all, though, was an unpolished gem. The same is true with the resources market.

Fast-forward to today.

Imagine you’re Rip Van Winkle and you go to sleep on 42nd Street back in, say, 1975 (let’s call you “Rip Van Wino”). You wake up in 2008 and see all the porno houses gone, bars shut down, strip clubs a distant memory... and then, suddenly, you are escorted to a homeless shelter because of New York policies on street people near 42nd Street...

Welcome to the new world.

In some ways, this is true of the commodity markets, too. When I got involved with commodities in 1988, the exchanges were the low men on the totem pole. The members held all the exchanges privately, and none were traded on the stock exchange. It was a secretive world, and the only way to get a job on the floor was to know somebody. I got my job because my best friend’s brothers owned seats on the floor and gave me a job as a clerk.

Everyone on the trading floor was either related to or knew someone in the biz; it was a very incestuous market. The basic reason was that there was so much money to be made in the market nobody wanted outsiders coming in. It was a shortsighted approach, but it was the rule of law down there. The problem was that the markets stayed small and took only a small percentage of the global investment pie.

As the early 1990s set in, commodities, basically, fell and/or stayed stagnant for much of the decade, except for during the occasional war, such as we had in 1990 and 1991 (oil went wild when Saddam Hussein invaded Kuwait).

The general public focused on stocks and still pooh-poohed commodities. Nobody talked about corn or soybeans at any cocktail parties I went to in 1991. Now it’s different. I must get 15 calls a week inviting me to speak about corn and soybeans at events or on TV. It’s been a paradigm shift from 1989 to 2009.

Question: If a bubble pops on Wall Street and all the traders are in the Hamptons, does it make a sound?

The most common question I have gotten on a weekly basis for the last 18 months is “When will the bubble pop?”

My answer is pretty standard: “There is no bubble!”

I am not usually invited back to those cocktail parties, as it scares the guests. The truth is we are not in a bubble. We are in an upward correction propelled by years of denial, stupidity, underinvestment and neglect. The blame falls squarely on several parties.

Wall Street is guilty for not embracing the commodity markets earlier. Wall Street should have allowed commodity prices to reflect the true nature of pent-up demand by making those markets available to its clients. Instead, Wall Street discounted commodities as some form of gambling.

The commodities exchanges and traders are also to blame for not making their markets more transparent, and for also projecting an image of secrecy and mystery.

And both Byron and I could tell you stories about the underinvestment in basic production over the past couple of decades. Really, what were people thinking? That prices were low, and would stay low forever? Did it ever occur to anyone that all those babies born in the 1970s and 1980s might some day grow up and want food, energy and manufactured goods?

No, this is not a bubble. It’s a coming of age, a big, hard reality check that has been decades in the making. I have seen more activity by Wall Street in the resource markets in the last three years than in the previous 17. And I do not expect that it will ever go back to the way it was. I also don’t expect to see 42nd Street filled with porno and hookers again, either.

Change is often hard to accept. $140 oil, $1,000 gold, $8 corn... this is all the new reality. None of these new price trends are a figment of some rogue speculator’s imagination or the products of evil activity. This is a wake-up call that our growing world is hungry for the limited resources it still has.

The most important thing to remember is that markets, even parabolic bull markets, always correct. Those corrections can be painful if one is overextended or married to one side of the market – in this case, the bull market.

So ride the wave of change, of course. Be flexible, buy on the corrections, sell for profits on the overdone rallies and vice versa. Go short when clear tops have been made (although I grant it can be hard to determine the exact top).

There is no trail of breadcrumbs to follow on Wall Street, but that’s why you have Byron and me to help guide you. As long as grains don’t go up too much more, we should be able to supply you with a good trail to follow for many years to come, whether commodities are in rally mode or consolidation.

Kevin Kerr
for The Daily Reckoning Australia

• Most Commodities Are in a Bull Market Today
• Outsize Demand for Commodities and Gold
• Commodity Inflation Causes Consumers to Cut Back on Spending
• Commodities, the Key to the Financial World
• Farmers Say ‘Rain, Rain Go Away’ Throughout the United States

Despite that fact, the debates rage over Peak Oil, Peak Food and peak everything else. It’s about as sensible as rearranging deck chairs on the Titanic. So the “experts” continue to debate whether or not resources are running low. But the evidence is pretty clear, at least to this trader.

In the past year, we have seen the oil and agriculture markets explode. And this could be just the beginning of the rally, not the end, as some would have you believe. Personally, I think we are about halfway to the new top for many commodities. That means $200 oil (easily) and gold at $1,500-2,000. The agriculture markets have even further to go, in my opinion.

Key commodities are becoming more and more scarce. So we can expect to see more suffering in the poorest countries first. Then the economic impact will work its way up the food chain (no pun intended).

The facts are fairly grim if we look at them closely. There is going to be less of everything. Yet there will be more people who want those things. Let’s face it – wars have been fought over far less.

In her famous book, On Death and Dying , Elisabeth Kubler-Ross describes the stages of grief:

• Denial: “It can’t be happening”
• Anger: “Why me? It’s not fair”
• Bargaining: “Just let me live to see my children graduate”
• Depression: “I’m so sad, why bother with anything?”
• Acceptance: “It’s going to be OK.”

In my opinion, the American public is going through the stages of grief right now. Rising prices are just a market-based signal that we are losing our economic and resource abundance. As the American dream fades away, it’s like a death in the family.

Right now, I think we are between the stages of denial and anger. Ask yourself these questions: What do you think when you pull up to the fuel pump and have to pay $4 for a gallon of regular gas, or nearly $5 for a gallon of diesel? Or how about when you go to the supermarket and have to pay $4 for a gallon of “store brand” milk, or the same price for a loaf of “store brand” bread? Are your emotions between disbelief and anger? Are you saying to yourself, “Hey, what the heck is going on?” (I’m cleaning it up a bit because this is a family-friendly publication.)

I think folks mistakenly thought prosperity would go on forever.

Dinner is always fun until the waiter brings the check. Or as my colleague Byron King once said, “It’s easy to look rich as long as you don’t ever pay the bills.”

No sector has recently hit Americans in the wallet harder than energy. But even with those dramatic price increases, major changes are still not happening. We have seen a very small decrease in gasoline usage – only about 1% or so.

But while some travel may be down as costs have gone up, the numbers are not really dramatic. No, I am not pointing fingers. I live here too. If I looked at my own lifestyle, I couldn’t say that I am making radical adjustments, either.

We still like to drive our big SUVs. We still drive alone to work. Most people rarely take public transportation (if there is any). And we love to run our air conditioners full blast while watching the documentaries on global warming and dying polar bears on our 62-inch plasma TVs.

Yes, we like to grumble when we fill up those big SUVs, mostly because it’s easier to complain than make the tough changes that are needed. We feel entitled to keep living as we do. Hey, after all, we’ve earned it. Right?

Rather than make difficult choices, we are in that denial stage and buy the line from the government and media that all is well.

The facts and the fiction often get mixed up when discussing the issue of “Peak Everything.” Take the surging price of crude oil. Some people (including a lot of politicians) want to blame the traders and speculators. Other people blame farmers and corn-based ethanol. A lot of people blame OPEC. The list of culprits goes on ad infinitum.

The fact remains that it’s not just one reason or another that we are in this energy disaster; it’s actually all of these reasons and others. It’s a culmination of many years of poor energy policy, short-sighted planning (if you can even call it planning) and an overdose of arrogance that only superpowers can have.

It’s like a football team saying, “We’re No. 1 and will always be that way.” So the team stops training hard. Players quit working out and coming to practice. The coaches just relax and forget about recruiting or developing new talent. Nobody designs new plays or bothers to scout the opponents to see what they are up to. And then the team expects to go out into the world and bring home the trophy every year. “Hey, we deserve it. Right?”

Or go back to the analogy of the Titanic. The ship was state-of-the art. It was not “supposed” to be able to sink. But now as the water rushes in and the ship is dropping lower and lower into the sea, the cold water is hitting us all in the face. Now our lawmakers are scrambling to plug the holes, and it’s not working. The smart people (or maybe they were just lucky) are already in the lifeboats.

Only time will tell if the United States can actually move into the acceptance stage. But in the meantime, commodities will continue to dwindle.

Kevin Kerr
for The Daily Reckoning Australia

• Supply of Conventional Crude Oil is Very Close to its Peak
• Peak Oil: What’s Next
• Peak Oil: Supply Data Doesn’t Lie
• Peak Oil – The Rewards
• Peak Oil – The Risks

Now don't get me wrong - as a child and young adult, I was fortunate enough to travel all over the world. My father made it a point to take us everywhere, and we often saw countries where there was poverty and no such things as running water, 7-Elevens or mega-malls, and where there were certainly no Starbucks, health care or gigantic well-stocked supermarkets. No, I was aware we had much more of everything in the U.S. - clearly, we had it better here. But as a child, I just never thought it could change.

Then I grew up.

When I was a kid, I would spend a lot of time at my grandparents' house on Sundays while my parents went to the Minnesota Vikings games - they were big fans. (Trust me, you had to be a big fan in those days - the stadium was outside, and it was darn cold in January. That was when NFL football was good.)

Anyway, my grandmother was in her 70s and had lived through the Great Depression and a couple of world wars, so she had seen hard times indeed. In her basement, she had a room that was filled from top to bottom with canned foods from her garden. It was an enormous garden filled with produce, not flowers. (Well, maybe a few flowers.) She also had a gigantic bin filled with coffee, and an even bigger industrial garbage can from Sears, filled with sugar. As a kid, I remember asking her why she had all that sugar in the garbage can. She replied, "Because you never know, Kevie." I had no idea what she meant. Now all I can think is how right she was.

Who knows, maybe she planted the seed right then and there for me to be interested in commodities trading? Heck, I would give a lot for Grandma's sugar-filled garbage can today, with sugar prices surging the way they have at the start of 2008.

As I have said for the last three years, the soft commodities are much undervalued, and we are seeing that move now just as we did in grains, and as we did in energies before that. The move higher in soft commodities like coffee, cocoa, sugar, cotton and others is just starting, not ending.

I really enjoy history. I can't say I am a scholar of history - I'm more like a History Channel buff. It's interesting that when we look at the history of food prices in America, we see that in 1901, people spent 43% - almost half - of their income on food, according to the Bureau of Labor Statistics. Do you know what that figure was in 2003? We will answer that in a minute.

It is true that since 1901, the percentage of our income spent on food has dropped dramatically, and it would seem to confirm a theory called Engel's Law. Engel's Law is the observation by 19th century German statistician Ernst Engel that "The proportion of income spent on food falls as income rises." But look deeper. Has spending gone down, or has it just shifted elsewhere?

Upon closer examination of my own spending, I realize that as I get older, my rising income has also meant more dining out. Restaurant dining and takeout food require even more energy, and are more expensive. Look at your own history, and you will see what I mean.

The extra money has certainly not gone into savings accounts, since the U.S. has one of the worst savings rates in the world, as well as some of the highest credit debt. According to the Bureau of Labor Statistics, the average American family spent $40,817 on goods and services in 2003. So where did all that money go?

OK, now the answer to our question. How much did the average family spend on food in 2003? Only about 14%, or a vast improvement over 1901, right?

Well, not really.

According to Advertising Age magazine, "Unlike in 1901, in 2003, the majority of the family budget went for the house (33 cents of every dollar) and car (19 cents). After paying for food (13 cents), medical bills (6 cents), a little booze (1 cent) and more, families had a nickel left to spend on entertainment." A nickel?

I just went to a Florida amusement park with my wife and baby, and at $200 for entry - trust me - a nickel is a little bit of an understatement.

And I will also say that in the area where I live in Connecticut, I see people living in these vast McMansions that cost $1-3 million. And they earn less than I do. I am just astonished. They must be spending 70%-plus of their incomes on their mortgages.

There is absolutely no doubt that consumer spending has increased exponentially since 1950. OK, let the good times roll. The government and die-hard bulls immediately point out that factoring in inflation, the increase is less dire. Maybe, but the "adjusted for inflation argument" won't feed your family or run your car. Try paying your mortgage and telling the bank that adjusted for inflation, your payment should be 30% less. See if they foreclose on only 30% of your house.

So we are all feeling the pinch of higher prices. We are used to increases in gasoline, health care and homes. We don't like it and we complain, but we expect it and we continue to fill up our Hummer and grumble and drive on. When it comes to groceries, however, and milk surging to $4.85 per gallon, look out.

How is this possible? How could it have happened? Ah, you can almost hear Marlon Brando saying, "The horror!"

My daughter turned 1 year-old in January. We always have to remind her not to play with her food. You would expect to have to do that with a 1-year-old. But you wouldn't expect to have to do that with our government leaders. (But come to think of it, many of them could use a good spanking.)

I am often asked by private clients, TV and radio interviewers, readers like yourself and others, "Why is this happening? Why are food prices surging?"

Simple. Stupidity, I think to myself.

The United States has some of the richest farmland in the world and more modern farming equipment than any other nation on Earth. The problem is we also use a lot of energy, and that is one thing we don't have much of. So what are we to do?

Then the political light bulb came on - dimly, but it came on. The idea was to turn a key staple of our food supply (corn) into fuel and thus create a panacea for the energy problem. This was a miracle, right? Wrong. Ethanol is nothing new; it has been around since cars first rolled out of Detroit. Ethanol from corn comes at a very high price. Not only does it require several steps to turn corn into ethanol, but it requires acres more of land, fertilizer, fuel, water, etc. At the end of the day, the only thing that widespread ethanol use is doing is destroying more of our natural resources while perpetuating the myth that we are doing something about our energy problem. It's almost criminal.

Now, don't get me wrong. Farmers have used ethanol for years locally, and in many instances, it makes complete sense. After all, growing a limited amount of corn on your own farm and refining it a few miles away at the co-op ethanol plant and then running your farm equipment and also pocketing a little coin at the same time - while providing some ethanol to the local community - made sense. Unfortunately, the government, lobbyists and politicians have perverted ethanol into a national mandate and thrown billions in subsidies to the industry.

It has become so absurd that farmers are becoming careless, throwing aside less-profitable crops like cotton and wheat.

In addition, being overlooked are prudent farming methods like crop rotation and not growing corn on corn, or the process of growing a different crop the year after you grow corn in a particular field. The environmental statistics are staggering, too.

In Wisconsin, for example, local rivers and tributaries have been dropping rapidly due to all of the extra water consumption - millions and millions of gallons. One local farmer in my farmers network says that he has lived in one location for 60 years and has never seen the lake near his farm so low. He says the local ethanol plant is talking about having water "shipped in." You have got to be kidding!

So what does all of this mean for us as investors? Plenty!

The days of cheap oil are already with us, and by adding certain key energy stocks to the OI portfolio, we, in essence, have a hedge against higher oil prices. We need to consider doing the same for food in our portfolio. I will tell you that in my own portfolios, I do have exposure to soybeans, wheat, corn and all the soft commodities. And they have done very well for me - as well as for our Resource Trader Alert members. In addition, stocks that will continue to benefit from rising food costs and global demand are companies like John Deere, Caterpillar, Monsanto, DuPont and The Andersons.

There is no doubt in my mind that oil prices will continue to go much higher, however. Eventually, when they get too high (that may be when oil is $600 per barrel), we may finally have a car that runs on switch grass, but clearly, this will not happen anytime soon. The difference between food and fuel is there is never going to be an alternative for food. We all need to eat, and there is no substitute. Did you ever chew on a piece of switch grass? I rest my case. The time to protect your portfolio from rising food costs is now. The days of cheap food are over.

Kevin Kerr
The Daily Reckoning Australia

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Wheat exploded this year on poor global crops and much higher demand. So is the big bull run for grains over? No, it's actually just getting started. While I think wheat, soybeans and corn will continue to do very well, another crop may do even better in 2008 - cotton.

The longer-term effect of all the extra corn and wheat planting in the South could be a cotton shortage and much higher prices for cotton and cotton futures.

The general consensus is that many farmers are switching out of less profitable crops like cotton and rice and moving into the lucrative corn and wheat market, which has benefited from the ethanol boom.

According to the National Cotton Council's early season planting intentions survey in 2007, U.S. growers intended to plant 13.2 million acres of cotton in 2007. This was a significant decrease of almost 14% from 2006, and 2008 is expected to be even more dramatic. Meanwhile, demand for cotton is showing no signs of slowing around the globe, especially in China.

China is wasting no time securing the natural resources it needs to keep its economy going - and that includes cotton. In fact, China's so serious it has created its own futures market.

Chinese merchants and manufacturers are very serious about the cotton business; all you have to do is look at cotton futures trading on the Zhengzhou Commodity Exchange.

The exchange is no joke and is the center of cotton trading in Asia. Daily volume in Zhengzhou cotton futures, which will complete their first year of trading on June 1, is now running about 50,000 contracts. Open interest at the ZCE has been running between 60,000-80,000 contracts per day since last November - that's just an incredible number.

To put it in perspective, 70,000 contracts per day is gigantic. It's amazing to think that the New York Cotton Exchange reached this level only after a century of trading. Literally, it took 120 years and a record U.S. cotton crop to accomplish it. The ZCE did it in less than a year. The power of China is amazing.

Even with all the global interest in cotton, cotton futures have sold off heavily and there is a lot of bearish sentiment - at least until now.

If the picture is so bullish for cotton, then why has it been selling off so much lately? Good question!

One big reason is demand has not been as high as expected in the first quarter, which has limited the upside trade in cotton, at least for now.

Cotton futures have had a bit of a boost in the last few months that will likely continue into 2008 because of speculative fund buying in cotton. The price for cotton is still relatively very cheap.

Analysis of the farming regions in the United States indicates that all areas will have some reduction of cotton. The South will be affected the most.

Another factor to keep in mind is Mother Nature. Weather is always a major factor for any agricultural commodity, and it will be pivotal in determining final crop size, no matter what.

When we apply each state's cotton yield in 2006 to its 2007 projected harvested acres, it generates a crop size of 20.5 million bales. At first glance, that's not all that bullish, since it's down only 1.2 million bales from the previous year's number. But if we examine the numbers a little closer and look at history, we see crops are often subject to yield deviations - in other words, coming in less than expected.

When we look back over the past decade, a pattern of deviations is obvious. It suggests that under ideal conditions, 22 million bales would not be out of the question, while weather problems could also push the crop to the 18 million bale range.

Timing is everything in trading commodities. Be sure to act on buying the cotton before the planting intentions report. The best way to trade cotton is using the December 2008 cotton futures and/or options on the New York Board of Trade.

Kevin Kerr
for The Daily Reckoning Australia

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In the commodities world, energy, metals and stock indexes have been the most active futures contracts - and the most talked about - for years. But like so many things in the commodities industry, that’s changing too.

Sure, oil and gold commentary still rolls off the lips of the various business news channel anchors. But nowadays, in the same breath, you may hear them talking about corn, wheat, or even soybeans. Why the sudden change?

The big push by individual speculators, hedge funds, and others into the agriculture sector in such a short time has been unprecedented. A great deal of this move is a direct result of the ethanol boom and the record corn prices it has helped to generate.

It’s pretty ironic that the modern commodities markets owe their success to the original grain markets that started it all. Back only a couple of decades ago, there was no such thing as an energy futures market or a stock market index. In fact, the grain markets were the first organised futures contracts when many of the exchanges started trading. As the markets developed, grains took a bit of a backseat and the financial and energy commodities seemed to take the lead.

Now with the emergence of the electronic trading market and the ethanol boom, grain futures are soaring. The global demand for agricultural and soft commodities is so significant that these markets are not only important, they are vital for price discovery once again.

The simple facts of the matter are that the global population is exploding and exponential increases in demand from countries like China and India are straining a system that is already overloaded by demand and has been taxed by weather problems globally.

The wheat crop has been hit especially hard this year as droughts, floods, disease, and even frost have taken their toll. Wheat has risen to US$9 a bushel, and US$10 is entirely possible later this year. Meanwhile, the soybean complex is also soaring, as pent-up demand, especially from China, is keeping this market very well supported.

It’s important to realise that not only do we have exponentially higher demand for soybeans from a growing world population, but we also have the increased feed demands of a growing cattle population in answer to more demand for beef. Soybeans are also a victim/beneficiary of the biofuel boom.

Combine all of these factors and throw in a little disease and bad weather and you have a recipe for a very hungry world, indeed…and much higher prices.

This has been an incredible year for agricultural commodities, and many “experts” have been telling me for the last year that I was crazy to buy these commodities at such high levels.

Of course, they started telling me that when corn was at US$2.20 a bushel and wheat at US$5.50. Today, corn is trading solidly over US$3.50 and wheat is trading close to US$9. The bad news for wheat supplies just keeps rolling in. In the latest round of bad news, Australia slashed its harvest forecast 31 % because of dry weather. Wheat is surging as importers line up to buy whatever wheat they can. Global inventories are heading for a 26-year low. Soybeans have outperformed expectations, too, as global demand has put a solid floor underneath prices.

Is all the bad news priced into the grain markets at this point, and have we finally seen the top for the grain rally? Think again. The biggest disaster for the grains may just be getting started.

According to my sources at farms in Minnesota and Iowa, diseases may be setting in, and this could be devastating to the wheat, bean, and corn crops.

Corn could be hit hard after a long summer, and hot and dry conditions and hail affected corn yields in Minnesota. The weather conditions favour the development of a disease called ear rot. Reports of ear rot have been coming in from several different areas, and the quality of grain that comes off these affected fields will almost certainly be reduced.
Meanwhile, things over in the bean patch are not faring much better. According to reports, early defoliation and death in patches of soybeans has occurred recently in fields across Minnesota.

According to Agriculture Online, “Although numerous soybean fields have started to mature and have suddenly turned yellow in the past week or so, it is obvious in many areas that the yellowing and plant death have been accelerated well beyond what would be typical.”

Sure, bean and grain prices are very high already — in fact, some of the prices we have been seeing for the agricultural commodities in the last few years are nothing short of astounding. It’s important to recognise, though, that demand has also been astounding. Demand is almost certain to outstrip supply, especially in wheat and soybeans. So even though we are seeing record prices, they may climb further as we head into winter. Therefore, some exposure to the agriculture sector in your portfolio seems like a prudent idea.

Clearly, the agricultural bull market is far from over, but that’s not to say that we won’t see some extreme volatility. Overall, though, the indications are pretty clear that staple commodities like grains are going to be more in demand and less in supply as time goes on.

So my forecast for the grain markets is as follows: Higher, but volatile.

The really nice thing about commodities trading is that it’s just as easy to bet on falling prices as on rising prices. So when the time does come, as it does in every market, we will be just as eager to go short and try to profit on the downside. For now, though, the trend is our friend and the trend is up.

Kevin Kerr
The Daily Reckoning Australia

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Now, I was no maths maven in school. I've struggled since Mr. Richardson's 6th grade maths tests, especially the five-minute one. (I still wake up in a cold sweat over that one.) Let me tell you, his maths tests kept me after school many a day and destroyed any interest in maths that I may ever have had.  All through the rest of my academic life I always did exceptionally well in vocabulary, reading, and writing, but stunk at maths in all forms except geometry, which my brain confused with drawing. Still, to this day, I'm a terrible mathematician and rely on all the modern-day conveniences, like accountants.

Anyway, if you spent a lot of time after school for maths as well, then you may think you're not able to trade options. Think again.

Some options books can be mind-boggling, with complicated mathematical equations and lots of detailed explanations that would mystify even Einstein, all to try and explain a simple concept.

We won't go into great detail here; there are plenty of resources for that on the Internet or in your local bookstore. All you need to do is understand the basics of buying options and how they can immediately benefit your portfolio in ways you couldn't imagine. Right about now you're probably saying, "OK, how?"

• Options limit risk and give you unlimited profits.
• Options give you tons of leverage in an already highly leveraged market.
• Options can allow you to trade markets you may not otherwise be able to afford to trade due to extremely high margins (e.g., natural gas, gold, crude oil).
• Options limit risk and give you unlimited profits. Worth repeating this one.

Before you do anything, you simply must learn the basics of buying options, there are no two ways about that - even the Maniac Trader had to succumb at some point! Forget your fear - if this 6th grade maths dropout can do it and be consistently successful, so can you.

So let's begin.  A "call" option is the kind of option we buy when we think the market is going higher; a "put" option is what we buy when we think the market is headed lower. Either way, the goal is the same: to make money from the difference between the strike price of the option and the current market rate of the investment. Right now we'll only discuss buying options.  Buying options, either puts or calls, involves limited risk and unlimited profit potential. You can sell options, also called "writing" options, but this carries with it limited profit potential and unlimited risk. Selling or shorting options is highly risky; if you're new to trading and even if you're not, many brokerage firms won't even let you do it.  So let's just focus on buying calls and puts.

When we buy a call or put we have to pay what is called "premium." Premium is a fancy way of saying what you're going to have to fork over for the option position. You can calculate what a fair premium should be in many ways, but at first it's best to work with a broker who has experience in calculating what a fair value for the option is; get them to help you learn how to do it and don't take no for an answer.

Most of the time you can find out where the option that you want to buy is trading just like you can get futures quotes-in the newspaper or on the Internet. If not, your broker can call the floor and get a fresh quote, much as they may do with spread orders. It's a good idea anyway, because sometimes there are so many options they don't all get updated and the price information on the screen may not be the most current. Always check first before trading.

Now I've gotten ahead of myself a bit.  Why exactly am I buying an option in the first place?  Why not just buy a cattle market futures contract if I think it's going higher? Great question. Answer: Two B-I-G advantages.

The first huge advantage is that when you buy options you're not required to put up any margin.  Nope…zip, zero, nada.  In other words, for something like cattle futures you would need to put up around $945 per contract as a guarantee or margin, and that money would remain locked up for the length of the trade. If you were to buy a cattle option instead, you would not have to post the margin at all, and could use that $945 toward other trades or simply keep it liquid. This is one of the greatest attractions of trading options: not tying up capital with margins.

Second, options allow you to control a vast amount of a particular commodity at a ridiculously low price. Leverage again - we love leverage! As you know, futures allow you to do this, but to a much lesser extent. Also futures carry unlimited risk as I pointed out earlier, while the risk in options is limited to just the premium you pay, nothing more.  Now the trick is finding bargains in options and knowing what the risk/reward potential is. This is where many traders come unstuck. 

Make no mistake, there are plenty of blunders people make when it comes to buying options, but a few really stand out and I'll share them with you now.

First, chasing the market doesn't pay. Never, never, never do this.  This holds true even more so for options than for futures.  Chasing after a trade in a market means you'll end up paying too much or selling for too little. In options trading this can mean the difference between consistently making and losing money.  Remember, options have an intrinsic value when you purchase them and the time value is always whittling away.  The option is constantly depreciating, like some new car from hell. So avid overpaying for an option at all costs - it will be even harder to turn a profit when it comes time to close the position.

Time is on your side…don't buy options with too little time value.  Time value is one of the most important things in options, and for that asset you have to pay more premium, but it can be worth it. The more time you have on your side the more chance your trade has of making money.  Buy too close in, say one or two months, and you may not have enough time until expiration for any real price movement. I don't advise trading options with less than three months until expiration or more than 18 months. 

Remember: "cheap" doesn't always mean good. Also, stay away from way out-of-the-money strike prices. Way, way out-of-the-money strike prices for commodities may be cheaper but the old saying, "you get what you pay for" usually applies.  If the option is so far out-of-the- money, say in heating oil, that it will take an ice-age to get to that price level, then "cheap" is a relative term.  Try to buy a strike price that's only slightly out-of-the-money unless you feel very strongly that the market is going to make a significant move in your favor; then you want to buy deep, way out-of-the-money options, as they're called.

There are plenty more pitfalls. And as important as knowing what not to do is learning what you should do to get a decent entry point for an option, which I will discuss next time.

Regards,

Kevin Kerr
for The Daily Reckoning Australia

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Two weeks ago, the average was USD$94.44 cwt, an increase of USD$3.32 over the previous week. Translation: Prices for cattle in the cash market are climbing fast and they will most likely continue to do so. Demand is the driver. As more countries reopen their markets to U.S. beef, demand will increase. Meat packer margins are hovering at break-even levels. Right now, tight cattle market supplies and plentiful inexpensive feed will likely result in a firming up of the cattle price. This holds true especially for cattle producers and feedlot operators.

Then, of course, there's avian flu. If one case of bird flu migrates to the United States and infects one person, people will swear off poultry and head right to the meat aisle in the supermarket. In reality bird flu is not actually spread by eating poultry, but often in trading perception is reality and just the threat of bird flu is enough to get the general public to shun poultry. Even though eating it isn't the cause of the illness, the general public won't differentiate. And who would want to bite into a chicken of death when they could opt for a nice juicy steak?

What mad cow? Typically, market participants have a short memory, so it's important to act on fear while it's still in full swing. The cattle and meat markets in general are the butt of many jokes in the investment world - Hillary Clinton's infamous cattle market trade comes to mind, as does the aforementioned question about pork bellies. Truth be told, the meats are a good agricultural market with solid fundamentals and can be a great learning market for the novice trader - just make sure no one knows you're a novice.

In 2006 I carried October live cattle positions and made some very good profits on the 86 call options, and later on the 88 call options. The cattle market is a volatile one and relatively illiquid, so it can be a difficult market if you're just starting out. You may want to avoid it until you get some experience.

The coffee, sugar, and cocoa markets are near and dear to my heart. These three commodities are also known as the tropicals, because most grow in the tropics, or softs, I guess because they're all soft in texture. But whatever you want to call them, these are some of the best performing and least understood or talked about markets. I spent much of my early career running between the pits of the coffee, cocoa, OJ, and sugar markets, and let me tell you, these are markets that trade like no others. Gold and oil may get the lion's share of the sound bites and headlines, but if excitement is what you're looking for, these markets have it.

Sugar, for example, is one of my favorites. It is growing exponentially in demand as a result of ethanol production and being widely used in foodstuffs; meanwhile the supply is shrinking due to factors such as European subsidies being curtailed. Sugar is likely to double in a couple of years, in my opinion, and the writing is already on the wall. Much the same can be said for markets like cocoa and coffee.

Worldwide demand is sucking up supplies faster then these commodities can be harvested. I know the coffee market well - very well, in fact. It's one of the first markets I traded when I started out in commodities 18 years ago. It's also one of the fastest-moving and most volatile markets, which means it's loaded with opportunity for you to make a lot of money. This is a good example for talking about one of the best features of trading commodities: the ability to short a market just as easily as going long. That's correct - unlike equities, you can short commodities futures just as easily as going long.

A market like coffee is particularly important because of its volatility but also because a new Starbucks pops up on every corner from Maine to China and every farmer who could possibly grow coffee beans is doing so, resulting in a glut of beans on the market. Even Juan Valdez, from the TV commercials, hung up his sombrero in 2006. Coffee is thus one of those markets you can play from both directions to get maximum profits - something futures allow you to do, with astounding results.

Cotton gave this maniac trader his start. My first full seat was on the New York Cotton Exchange (now the New York Board of Trade). My badge was 8015 QUEST, as in Jonny Quest. (I was young and had blonde hair and a dog named Bandit; when the guys on the floor found out I had done cartoon voiceovers as a kid, the name just stuck. Everyone gets a nickname down there, and it usually isn't something you'd choose for yourself.)

In any case, cotton is an "old boy" market, much like the cattle market or the grain market - not old as in stale, but old in that it has been around a very long time and the people who trade it have been doing it a very, very long time. Cotton is a great market to trade, but you must understand the fundamentals at work and the differences between old crop and new crop. This simply means that two different cotton crops are produced each year in cotton, and you must make sure you know which crop you're looking at and then make your decisions based on that. Cotton is one market that's crucial not to underestimate and, much like the ocean, never turn your back on. Trust me, I worked in there for a number of years.

Right next door is another very active market, especially in the winter and during hurricane season: orange juice. Orange juice is a perfect market for learning about fundamentals the hard way. Many of you have seen the movie Trading Places, with Eddie Murphy and Dan Aykroyd. If you haven't seen it, do - it will give you a good laugh. The movie was filmed on the old World Trade Center trading floor and was about trading OJ, but the reality stops there (or does it?). Actually, with tongue in cheek, I can say that it's probably a fair depiction of the old trading pits.

Today, however, the OJ market is tightly controlled by supply and demand and is certainly ruled by weather factors - not just winter hard freezes, either. It may surprise you to know that hurricanes in Florida are the biggest factor influencing this market, not only before the hurricane hits but after, too. The main concern is citrus canker; after the winds and rain die down, this fungus can develop on the crop. Fundamental information like this is important to know and take into consideration when initiating a position.

Every market is different, so you must study the fundamentals for all of them. For example, you must understand what soybean meal is used for as opposed to soybean oil. Soybeans are used for biofuel, among many other things, so nowadays soybean prices more closely parallel those of crude oil and heating oil than those of the regular crop reports.

Keep in mind that these markets move on the basis of supply and demand. Right now, the demand for soybeans is picking up in a big way due to biofuel consumption, which in turn relates to how high heating oil prices are. It's not hard to connect the dots to identify what affects a specific commodity, but sometimes you've got to do a little research first. Biofuel is used primarily for home heating, and as ethanol is derived from corn, biofuel is derived from soy. The bottom line is that you must know, inside and out, the basics about whatever commodity you choose to trade, whether it's rough rice or natural gas.

More importantly, you need to know new factors that may affect a particular market - and these can change.

Regards,

Kevin Kerr
for The Daily Reckoning Australia

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Technicals versus fundamentals, which is better? This is an ongoing argument among traders, but actually they're both necessary. I use both technicals and fundamentals, and I firmly believe it's vital to have a well-rounded knowledge of both in order to be a successful trader.

The trick is to know when to rely more on one or the other, or sometimes even neither, and just go with your intuition - your gut - sometimes, for some of us, this is the best indicator of all. Certain commodities, such as crude oil, tend to make use of the fundamentals; others, such as financials, rely more heavily on technicals.

Kevin Kerr
The Daily Reckoning Australia

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You don’t have to move in together, but just show that you’re making an effort to understand what they do and how they do it. The best brokers will call you when they see an opportunity or, in other cases, a problem, with your account. They will be quicker to do this if they like you. They can tell you what trades are simply not a good idea, help you understand terminology and even decipher the various industry reports, and a lot more. Even better, brokers like clients who have a basic understanding and try to learn the workings of the market. When you have that understanding you have an instant edge over the vast majority of novice commodities traders.

Kevin Kerr
for The Daily Reckoning Australia

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Anyway, let me be clear - I make use of the media and information superhighway every day. While I have colleagues who are deep philosophical thinkers who don't even own a TV, I have five computer screens in my office and two televisions. Does this make me non-philosophical and obtuse? No, because most of the time I keep the volume on the TV down, which improves my IQ immensely.

Distractions of any sort when trading can be of little or no value. The TV blaring opinions that change moment-to-moment can be one of a trader's most useless tools. A friend and colleague of mine, we'll call him Jack, used to work in the office across from mine. Jack is one of the best currency traders I know and he and I come from the same mold. Jack never had a TV in his office; he thought it was worthless and that what was said was mostly drivel. For the most part he was right. More importantly, Jack's point was that TV offered him nothing beneficial for his trading--it only interfered with his system and was a distraction; in other words, just noise. I agree with Jack. I also feel that staring at a trading screen all day long is useless.

Markets move up and down and when they move against you, when the screen is totally red, emotion can creep in, and we all know how detrimental that can be. I suggest sometimes that you simply switch off the screen and do something else. Pet the dog, make a sandwich, go to the gym, make another sandwich (there have been some years where I've gained 20 pounds!) - my point is to leave the scene and clear your head, then come back and decide what to do. You may be amazed at what you find when you return!

Jack was a funny guy; he had very little in his office: a little box over in the corner, a few books on the desk, a light and that was about it - maybe one picture of his family. Truly a minimalist. My office, on the other hand, had tons of stuff in it--pictures books, plaques, TV blaring, etc. So one day I went into Jack's office and I asked him "Not for nothing Jack, but what's the box for, and why don't you keep more stuff in your office?" He looked at me and said, "I can fit everything I have in this office in that little box in about two minutes." Jack's point was that he wanted to be ready to go at a moment's notice. After being a professional trader for a number of years you come to learn that no matter where you're working as a trader it all comes down to results, you're only as good as your last trade.

Now is that true? No, but it's the perception. Truthfully, the media can be an invaluable source of new information and also a good contra-indicator. In other words, if everyone on TV or in the press is talking about how strong copper is, or crude oil, it may be time to look for a downside move, not always, but sometimes.

My advice is to use the news and information as a resource; pull out what you need and leave the rest behind. It's quite possible to be bombarded 24/7 by talking heads and then have no idea what to do. The best plan is to pick one or two trusted information sources, then lay out your own disciplined game plan and stick to it. Alter it occasionally but never stray too far or too fast. You can always hit the mute button on the TV--sometimes that's your best move.

You'll preserve more of your sanity if you tune out all of the opinion and stick with the facts on which you should have based your trades in the first place. Moving your positions with every sound byte on TV only makes one person rich - your broker. Don't do it!

In the world of commodities, figuring out which data NOT to look at can be just as important as knowing what you absolutely must follow on a regular basis. Each commodity is different and learning what's important for corn is a lot different than learning what you need to watch for crude oil. Government numbers such as employment data, GDP, and Federal Reserve announcements impact almost all markets, even the global ones. It's important to have an understanding of the key reports and, even more essential, how much emphasis the markets place on them. Certain reports carry more weight with traders than others.

In addition, as a market changes and matures, certain reports may lose their relevance and new ones may come into play. For example, back when I started in the crude oil markets, everyone followed the American Petroleum Institute report (API), the benchmark report for oil inventories. Not anymore. These days, traders monitor the Energy Information Agency (EIA) report.

Key government reports have been around for as long as the markets and they rarely change. Unemployment numbers, trade deficit, GDP, consumer sentiment. These all are major indicators of the state of the economy, and traders should know when these numbers are going to be announced or published.

I've found that the hardest part about any information or number is not only understanding what it means but, more importantly, anticipating how the markets will react to the data. The second part of this equation is a thousand times more difficult than the first.

For example, if the EIA data for crude oil comes out on a Wednesday morning and it shows a build in crude oil supplies, will the market perceive that as bullish or bearish? In other words, if the report shows more crude oil on hand than expected, you would think that would tell traders the market is heading lower. Not always. Sometimes traders may figure that OPEC will see that supply is higher and immediately cut production, which will have an impact on supplies down the road. So while the front couple of months may drop in price, if you own futures further out they actually could go higher. Commodities trading is like one big chess game; I advise being the knight, not a pawn. You always need to be flexible and agile when trading "off of the numbers." Remember not to get tunnel vision and don't fight the trend after a number, chances are very good that the trend will win.

"Buy the rumor, sell the news" is a common traders' saying, and for good reason. But once again this is not always the best advice. Sometimes what happens is that the markets will already "price in" the anticipated data; then when the numbers are released it's a bit of a letdown from the hype before the number, thus "buy the rumor, sell the news." Another favorite old-time saying I used to hear was, "Those who trade headlines end up selling newspapers."

Here are some of the key reports professional traders follow:

Commitments of Traders (COT) - A report published every Friday by the Commodity Futures Trading Commission (CFTC) that provides investors with up-to-date information on futures market operations and increases the transparency of the exchanges. This is one report that traders rely on heavily, and so should you.

Volume and Open Interest - We talked about this. Open Interest shows us how many people are actually trading any particular market at a given time. The higher the open interest the safer, or at least more liquid a market is to trade.

Commercials' Positions - This shows what commercial and end users are doing. Commercials buy more than individuals, or sell more, depending on market conditions. Traders put a lot of stock into what the commercials are doing because they carry a lot of weight in the market and often control the majority of the open interest.

Unemployment Claims - Jobs are the lifeblood of the economy so traders pay very close attention to these numbers.

Interest Rates - Interest rates affect almost every aspect of people's lives, especially borrowing, and that can impact the ability of traders to invest, so it's important to keep an eye on the Federal Reserve at all times.

More specific to certain commodities are reports such as:

Cattle on Feed - Shows the number of cattle that are in the process of getting ready for slaughter

Crop Progress Report - Shows the condition of the current corps and how and in what condition they may harvest.

Crop Reports for OJ - Shows the orange crop estimates and potential damage from weather, pests, or disease.

EIA Report for Oil - A weekly inventory report, appearing every Wednesday, for crude oil and products derived from it

Natural Gas Inventories- Same as the EIA report for Crude Oil, except it comes out on Thursdays and only measures the amount of natural gas in storage in cubic feet.

...and many others.

Like any tool in our trading toolbox, these reports can help us make an educated trading decision, but remember they are only one tool. Putting all of your eggs in one basket is never a good idea. Take the numbers with a grain of salt and try to anticipate how the market will react to any given number release. It's a good rule of thumb to be on the sidelines for any major announcement because trading ahead of a number is highly risky and often very unpredictable, but then again that's what many investors want. As you gain experience, you'll be able to see where you want to be.

Regards,

Kevin Kerr
for The Daily Reckoning Australia

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