Commodities, whether they are related to food, energy or metals, are an important part of everyday life. Similarly, commodities can be an important way for investors to diversify beyond traditional stocks and bonds, or to profit from a conviction about price movements.


It used to be that most people did not invest in commodities because doing so required significant amounts of time, money and expertise. Today, there are a number of different routes to the commodity markets, and some of these routes make it easy for even the average investor to participate. This article should help you determine which tools will suit you best for investing in commodities.

Futures Market
A popular way to invest in commodities is through a futures contract, which is an agreement to buy or sell, in the future, a specific quantity of a commodity at a specific price. Futures are available on commodities such as crude oil, gold and natural gas, as well as agricultural products such as cattle or corn.


Most of the participants in the futures markets are commercial or institutional users of the commodities they trade. These hedgers may use the commodity markets to take a position that will reduce the risk of financial loss due to a change in price. Other participants, mainly individuals, are speculators who hope to profit from changes in the price of the futures contract. Speculators typically close out their positions before the contract is due and never take actual delivery of the commodity (e.g. grain, oil, etc.) itself.

Investing in a futures contract will require you to open up a new brokerage account, if you do not have a broker that also trades futures, and to fill out a form acknowledging that you understand the risks associated with futures trading.

Each commodity contract requires a different minimum deposit, depending on the broker, and the value of your account will increase or decrease with the value of the contract. If the value of the contract goes down, you will be subject to a margin call and will be required to place more money into your account to keep the position open. Due to the huge amounts of leverage, small price movements can mean huge returns or losses, and a futures account can be wiped out or doubled in a matter of minutes.

Most futures contracts will also have options associated with them. Options on futures contracts still allow you to invest in the futures contract, but limit your loss to the cost of the option. Options are derivatives and usually do not move point-for-point with the futures contract.


Advantages:


  • It's a pure play on the underlying commodity.
  • Leverage allows for big profits if you are on the right side of the trade.
  • Minimum-deposit accounts control full-size contracts that you would normally not be able to afford.
  • You can go long or short easily.
Disadvantages:

  • The futures markets can be very volatile and direct investment in these markets can be very risky, especially for inexperienced investors.
  • Leverage magnifies both gains and losses.
  • A trade can go against you quickly and you could lose your initial deposit (and more) before you are able to close your position.
SEE: Get Into Low-Cost Futures Trading With Synthetics

Stocks
Many investors looking for a commodity play use stocks, which are less prone to volatile price swings than the futures market. Stock investors need to do some research to help ensure that a particular company is a good investment as well as a good commodity play.


Oil companies allow investors to select from drillers, refiners, tanker companies or diversified oil companies. Stocks are easy to buy, hold, trade and track, and it is possible to play a particular sector.

Stock options, which require a smaller investment than buying stocks directly, are another way to invest in commodities. While risk is limited to the cost of the option, the price movement will not usually directly mirror the underlying stock.

Advantages:

  • Investors usually already have a brokerage account, so trading is easier.
  • Public information on a company's financial situation is readily available.
  • The stocks are often highly liquid.
Disadvantages:

  • A stock is not a pure play on commodity prices.
  • Its price may be influenced by company-specific factors as well as market conditions.
Exchange Traded Funds and Exchange Traded Notes
Exchange traded funds (ETFs) and exchange traded notes (ETNs), which trade like stocks, allow investors to participate in commodity price fluctuations without investing directly in futures contracts.


Commodity ETFs usually track the price of a particular commodity or group of commodities that comprise an index by using futures contracts, although a few back the ETF with the actual commodity held in storage.

ETNs are unsecured debt designed to mimic the price fluctuation of a particular commodity or commodity index, and are backed by the issuer. A special brokerage account is not required to invest in ETFs or ETNs.

SEE: ETFs Provide Easy Access To Energy Commodities

Advantages:

  • Because they trade like stocks, there are no management or redemption fees to worry about.
  • They provide an easy way to participate in the price fluctuation of a commodity or basket of commodities.
Disadvantages:

  • A big move in the commodity may not be reflected point-for-point by the underlying ETF or ETN.
  • Not all commodities have an ETF or ETN associated with them.
  • ETNs have credit risk associated with the issuer.
Mutual Funds and Index Funds
While mutual funds cannot invest directly in commodities, they can invest in stocks of companies involved in commodity-related industries, such as energy, agriculture or mining. Like the stocks they invest in, the fund shares may be affected by factors other than commodity prices, including stock market fluctuations and company-specific risks.


SEE: An Introduction To Sector Funds

A small number of commodity index mutual funds invest in futures contracts and commodity-linked derivative investments, thus providing more direct exposure to commodity prices.

Advantages:

  • Professional money management
  • Diversification
  • Liquidity
Disadvantages:

  • Management fees may be high, and some of the funds may have sale charges as well.
  • Because most commodity mutual funds invest in stocks, they are not a pure play on commodity prices.
Managed Futures
A commodity pool operator (CPO) is a person or limited partnership that gathers money from investors, combines it into one pool and invests it in futures contracts and options. CPOs do need to provide a risk disclosure document to investors, and they must distribute periodic account statements as well as annual financial reports. They are also required to keep strict records of all investors, transactions and pools they may be running.


CPOs will employ a commodity trading advisor (CTA) to advise them with the trading decisions for the pool. CTAs must be registered with the Commodity Futures Trading Commission (CFTC) and are required to go through an FBI background check before they can provide investment advice. They usually have a system to trade futures and use it to advise commodity-pool trades.

SEE: A Primer On Managed Futures

Advantages:

  • Professional advice
  • A pooled structure that provides more money for a manager to work with
  • Closed funds require all investors to put in the same amount of money
Disadvantages:

  • It may be difficult to evaluate past performance, and you may want to look at the CTA's risk-adjusted return from previous investments.
  • Investors should also read CTA disclosure documents and understand the trading program, which may be susceptible to drawdowns.
The Bottom Line
There are different types of commodity investments for novice and experienced traders to consider. Although commodity futures contracts provide the most direct way to participate in price movements, other types of investments with varying risk and investment profiles also provide exposure to the commodities markets. The key is to invest with the tool that works best for you.




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