If you are interesting in investing in commodities, there are many ways to go about. One doesn’t even have to own a commodity to benefit from price fluctuations in the market price. Below, we will take a look at a few options for investing and speculating. The list is by no means exhaustive – there are many other venues available in addition to these for investors and speculators hoping to make a profit from commodity price changes.
Futures contracts
A commodity futures contract is an agreement between one contract party to sell, to the other contract party, a specified quantity of a specific commodity at a specific price at a pre-determined future date or time period.
Futures contract are available for a wide range of commodities, e.g. gold, silver, copper, corn, sugar, crude oil and natural gas – just to mention a few. One of the advantages of futures contracts is that they make it very easy to go long or short.
The commodity futures contracts market rely largely on the actions of commercial and institutional user of the underlying commodities. Many companies that are in the commodity industry or rely on commodities for their business use futures contracts to manage risk.
The commodity futures contracts market also contain participants that are only there with the hope of making a profit from commodity price changes. These participants are not interested in actually taking delivery of any commodity. In many cases, they wont even wait to cash-settle the futures contract as it expires. Instead, the close out their positions in advance.
If you are an ordinary hobby investor that wish to buy and sell commodity futures contracts, there are plenty of brokers to chose among online. You will most likely be required to fill out a form acknowledging that you are aware of the risks associated with futures trading.
Leverage
For hobby investors, futures trading is typically combined with leverage. This means that you borrow money from your broker to make trades. By doing so, you don’t have to deposit $100,000 into your broker account to have $100,000 in open positions – you only have to deposit a fraction of this.
How much leverage you can use is determined by the broker and the value of the assets in your margin account. The value of the money or other assets in your margin account will determine how large the total open positions are allowed to be for you, at any given point. If the value of the assets in your margin account drop too low, you will be asked to either close one or more positions or make a new deposit into the margin account.
Using leverage is popular since it makes it easier to profit from small price movements even with a small bankroll. However, using leverage is very risky because you can end up losing more money than what you deposited or ever had in your account. Even a small price movement can trigger a situation where your open positions are closed automatically by the broker (unless you immediately put enough cash into the margin account), realizing the losses and leaving you with a huge debt to the broker.
Options on futures contracts
It is common for commodity futures contracts to have options associated with them. Buying options on futures contracts instead of buying futures contracts outright is a way of limiting the possible downside of the trade.
Please remember that the market price for an option on a commodity futures contracts rarely mirror the price movements of the futures contracts exactly.
Binary Options
Most binary brokers offers binary options than can be used to speculate on the future value of commodities. It is possible to earn money during both negative and positive market conditions. Binary options give you a high return if you correctly predict if the value of a commodity will go up or down. Read more about commodity based binary options.
Commodity Mutual Funds
The strict legal definition of a mutual fund varies from one jurisdiction to the next, but when we talk about mutual funds we typically mean an actively managed open-end collective investment vehicles sold to the general public. In a mutual fund, money from several investors is pooled to make investments. The mutual fund is professionally managed, and as an individual investor you have legal right to decide how the money is invested once it has entered the fund. Mutual funds are therefore popular among investors that doesn’t want to be involved in day-to-day trading decisions.
Alternatives to the common open-end mutual fund is the closed-end mutual fund and the unit investment trust. Unlike the open-end mutual funds, these two alternatives are not obliged to buy back shares from investors every business day if the investor wants to sell shares.
A commodity-based mutual fund is a mutual fund that invests in commodities, either directly or indirectly. They can of course purchase commodities, but it is also possible to trade in futures contracts, commodity options and similar commodity-linked derivative instruments. Investing in shares of companies in the commodity industry is a very popular choice for mutual funds with a commodity profile.
By pooling their money in a mutual fund, investors can attain a higher degree of diversification since a larger amount of investments can be done. Example: You have $5,000 to invest. You realize that if you buy shares directly in good looking companies in the commodity industry, you can only invest in a very small number of companies and commodity sectors before you have invested all your money. If you were to pool your $5,000 with 20 other people who also put $5,000 each into the pool, you would have $100,000 to invest. This would allow a much higher degree of diversification. You can buy stocks in a larger selection of companies, making sure that you also diversify well when it comes to commodities, commodity groups and geography. You can also make other investments in addition to the stocks, e.g. investing in commodity-backed derivatives.
Before you invest in a mutual fund, be aware that management fees tend to be high and some mutual funds incur a lot of expenses that reduce their profitability. Also, some funds charge hefty sales charges.
In the United States, all mutual funds – not just the ones that invest in commodities – must be registered with the U.S. Securities and Exchange Commission, managed by a Registered Investment Advisor and overseen by a board of directors or board of trustees. If the mutual fund comply with certain requirements under the U.S. Internal Revenue Code, it will not be taxed on its income and profits.
Commodity index fund
The index fund is a type of mutual fund, but it is not actively managed in the way a normal mutual fund is. Instead it is passively managed and the investments are put together to follow an index. Index funds are passively managed funds.
In the case of a commodity index fund, the fund follows an index consisting of a group of commodities.
N.B! Some exchange traded funds are also known as index funds, since they track an index.
Commodity ETFs & Commodity ETNs
ETF = Exchange-traded Fund
ETN = Exchange-traded Note
Since ETFs and ETNs are listed on exchanges, they are highly standardized and easy to trade, and the liquidity is usually high. If you invest in commodity ETFs or ETNs, you can make profits (or losses) from commodity price fluctuations without investing directly in commodities or even commodity futures contracts.
Please note that a move in commodity price might not be mirrored by an identical move in the valuation of the ETF or ETN.
Commodity ETN
The Commodity ETN is intended to mimic the price fluctuations of a particular commodity or group of commodities that comprise an index. The ETN is unsecured and is backed by the issuer, which means that for the investor there is a credit risk associated with the issuer.
Commodity ETF
A typical Commodity ETF will track the price of a particular commodity or group of commodities that comprise an index. The fund will achieve this through futures contracts, and some funds also own the actual commodity or commodities.
One of the pioneers in the field is Barclays Global Investors (BGI) who is now a very big player in the commodity ETF industry. Another driving force was Benchmark Asset Management Company Private Ltd in India, who proposed the idea of gold-based ETFs to the Securities and Exchange Board of India in May 2002.
The Gold Bullion Securities exchange-traded fund was launched on the Australian Securities Exchange (ASX) in 2003. Australia is the second largest gold mining country in terms of output, so it wasn’t surprising that this important step in the history of gold speculation took place there.
For silver, the first exchange-traded ETF was iShares Silver Trust, launched on the NYSE in 2006.
Important
In the United States, an ETF that doesn’t invest in securities is not regulated as an investment company under the Investment Company Act of 1940. The public offering is still subject to SEC review and the ETF must obtain a SEC no-action letter under the Securities Exchange Act of 1934. The ETF may also fall under the auspices of the Commodity Futures Trading Commission.
Commodity Pool
A commodity pool operation (CPO) gathers money from investors and combines it into one pool. The pooled money is used to make commodity investments, typically in the form of futures contracts and commodity options. By pooling money, larger investments can be made and a skilled trader can make advanced and complex risk management decisions that wouldn’t be possible with a small bankroll.
Closed CPO:s require all investors to put in the same amount of money. For other CPO:s, there is no such requirement.
Putting money into the hands of a CPO is popular among investors that wants professional help making investment advices and doesn’t want to be involved in the day-to-day decision making. A commodity pool operation can also be used to diversify an investment portfolio where you are already doing a lot of direct investment choices on your own, and want the input of someone else as a way of managing risk.
The legislation regarding CPOs vary from one jurisdiction to another. Examples of important aspects to check up on in advance:
- Is the CPO legally required to provide a risk disclosure document to investors?
- Is the CPO legally required to distribute periodic account statements?
- Is the CPO legally required to distribute annual financial reports to investors?
- Is the CPO legally required to keep strict records of transactions?
In the United States, a CPO will employ a commodity trading advisor (CTA) to help with trading decisions, and this CTA must be registered with the Commodity Futures Trading Commission (CFTC). If possible, check out the CTA’s risk-adjusted return from previous investments before you make any decision.
Investing directly in companies
Instead of investing directly in commodities, one can invest in companies that one believes will benefit from a certain commodity or certain commodities increasing in price. One of the easiest ways of doing this is to purchase shares in stock companies.
Compared to the futures market, the stock market tend to be less volatile. Still, investing in stocks is far from risk-free and investing in “commodity stock companies” come with its own sets of pros and cons that should be taken into account before any trading decision is made.
When you invest in a company instead of in a commodity, you add a lot of addition factors that may impact your profits or losses. For instance, a miss managed company can fail to profit from increased commodity prices. Natural disasters can wipe out crops for your company, meaning that it won’t see any profits from an increase in commodity price that year. Factors at the production location – from wages and weather to corruption, legislation and taxes – can impact the bottom line of the company independent of the world market commodity price. These are just a few examples of factors that need to be considered before one invests in a stock company active in the commodity industry.
One should also keep in mind that to protect themselves from volatility, many companies in the commodity sector carry out extensive price hedging – sometimes up to 1,5 years in advance. A sudden spike in commodity price that would send a futures contract through the roof might therefore not have any major impact on company profits and company share price.
Stock options
Stock options will typically required a smaller investment than buying stocks directly. Please note that price movements in stock option market price rarely directly mirror the price movements of the underlying stock.