Secret 13USE THE LAWS OF SUPPLY AND DEMAND

When dealing with commodities and commodity options,

the laws of economics can be a valuable predictive tool. Here,

again, you use extremes to predict the future.

Unlike stock—where a large number of variables determine

the performance of a stock price—commodities’ prices usually

will comply closely with the laws of supply and demand.

For example, many years ago there was a freeze in the

Southeast that killed off almost 1/3 of all the orange trees in several

states. This resulted in orange juice prices racing up from

$1.25 per pound to over $2.20 per pound, and a 1-cent move is

equal to $150 on one contract; therefore a sizable move. However,

a large amount of orange juice is produced in Brazil. Hence,

with such a high price for orange juice, large quantities of Brazilian

imports drove the price down to $1.00 per pound—far below

where it started its rally.

Here we see the laws of supply and demand in action. When

prices get too high, purchasers stop buying or find substitutes,

and suppliers rush in to take advantage of these high prices. As a

result, demand dries up and supply greatly increases, causing the

commodity to fall in price, sometimes dramatically, as in the case

of orange juice.

The reverse is true when prices are really low. Demand increases,

due to a low price, but supply dries up because farmers

or suppliers don’t want to sell their goods at low prices. Therefore,

farmers will stop growing the crop that is low in price, and

eventually the price must rise.

However, sometimes other factors will delay this process.

For example, several years in the 1980’s, copper was selling for

about 50-cents an ounce, far below production costs. Why? Third

World nations that had copper reserves were desperately producing

copper below cost in order to make the interest payments on

their huge Third World loans from Western nations. This long

hiatus caused many U.S. copper mines to shut down. Eventually,

the low copper price and the removal of copper mines from production

caused copper to run up above $1.50 an ounce, but it

took a long while for the laws of supply and demand to kick in.

The laws of supply and demand are laws of science. Eventually,

they will work in the market place, so, as an option player, try to use these to your advantage. You may say, “Why don’t I just

buy the futures contract, put down a small good faith deposit and

wait, instead of paying an option premium?” Well, the big problem

is how high is high and how low is low? If you think a commodity

price is really low and you buy a futures contract, you

have extensive risk if it keeps falling in price.

For example, at one time sugar dropped down to 5-cents a

pound, and everyone said it could not go any lower. Well, it

dropped down to 2-cents a pound, and each cent is equal to

$1120. So, when you purchase a futures contract to catch the

low, it is like trying to catch a falling knife; you can get hurt.

Options, because of their limited risk, are ideal for taking a

position if a commodity is really high or really low in price. If you

buy a call and the futures price still falls, all you can lose is the

money you paid for the option; then, once it expires, you can roll

into a new position, and if you use patience, you will eventually

hit that home run.

If you plan to buy commodity options when commodities

are too high or too low in price, you must be really patient, waiting

for the ideal time to buy, then waiting for the option to pay

off and, if it expires, rolling into a new option position—waiting

for that home run when the laws of supply and demand kick in.

U S E T H E L AW S O F S U P P LY A N D D E M A N D

When dealing with commodities and commodity options,

the laws of economics can be a valuable predictive tool. Here,

again, you use extremes to predict the future.

Unlike stock—where a large number of variables determine

the performance of a stock price—commodities’ prices usually

will comply closely with the laws of supply and demand.

For example, many years ago there was a freeze in the

Southeast that killed off almost 1/3 of all the orange trees in several

states. This resulted in orange juice prices racing up from

$1.25 per pound to over $2.20 per pound, and a 1-cent move is

equal to $150 on one contract; therefore a sizable move. However,

a large amount of orange juice is produced in Brazil. Hence,

with such a high price for orange juice, large quantities of Brazilian

imports drove the price down to $1.00 per pound—far below

where it started its rally.

Here we see the laws of supply and demand in action. When

prices get too high, purchasers stop buying or find substitutes,

and suppliers rush in to take advantage of these high prices. As a

result, demand dries up and supply greatly increases, causing the

commodity to fall in price, sometimes dramatically, as in the case

of orange juice.

The reverse is true when prices are really low. Demand increases,

due to a low price, but supply dries up because farmers

or suppliers don’t want to sell their goods at low prices. Therefore,

farmers will stop growing the crop that is low in price, and

eventually the price must rise.

However, sometimes other factors will delay this process.

For example, several years in the 1980’s, copper was selling for

about 50-cents an ounce, far below production costs. Why? Third

World nations that had copper reserves were desperately producing

copper below cost in order to make the interest payments on

their huge Third World loans from Western nations. This long

hiatus caused many U.S. copper mines to shut down. Eventually,

the low copper price and the removal of copper mines from production

caused copper to run up above $1.50 an ounce, but it

took a long while for the laws of supply and demand to kick in.

The laws of supply and demand are laws of science. Eventually,

they will work in the market place, so, as an option player, try to use these to your advantage. You may say, “Why don’t I just

buy the futures contract, put down a small good faith deposit and

wait, instead of paying an option premium?” Well, the big problem

is how high is high and how low is low? If you think a commodity

price is really low and you buy a futures contract, you

have extensive risk if it keeps falling in price.

For example, at one time sugar dropped down to 5-cents a

pound, and everyone said it could not go any lower. Well, it

dropped down to 2-cents a pound, and each cent is equal to

$1120. So, when you purchase a futures contract to catch the

low, it is like trying to catch a falling knife; you can get hurt.

Options, because of their limited risk, are ideal for taking a

position if a commodity is really high or really low in price. If you

buy a call and the futures price still falls, all you can lose is the

money you paid for the option; then, once it expires, you can roll

into a new position, and if you use patience, you will eventually

hit that home run.

If you plan to buy commodity options when commodities

are too high or too low in price, you must be really patient, waiting

for the ideal time to buy, then waiting for the option to pay

off and, if it expires, rolling into a new option position—waiting

for that home run when the laws of supply and demand kick in.

U S E T H E L AW S O F S U P P LY A N D D E M A N D