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Investing in commodities is an invaluable skill every investor should possess. Commodity investments not only offer significant profit opportunities but also help diversify your investment portfolio. However, they come with substantial risks. Therefore, before investing in any commodity, it's crucial to thoroughly understand the basics of that market and its associated risks.
Steps
Understand what commodity investment entails
Familiarize yourself with the concept of commodities. Commodities are not just simple goods; they are interchangeable with other goods of the same type and are typically produced and sold by various companies. For example, a barrel of a specific type of crude oil, such as Brent crude, is identical regardless of the producer.
- This contrasts with consumer products like computers or cars. Products from different manufacturers vary and cannot be easily exchanged.
- Note that while some specific commodities may have differences in quality and characteristics (e.g., Brent crude generally has higher quality than West Texas Intermediate crude), producers are often willing to exchange products of the same type with other producers.
- There are many different types of commodities, including gold, oil, natural gas, coal, copper, zinc, potassium, nitrogen, phosphate, live cattle, pork, orange juice, cotton, sugar, coffee, and many more.
Explore the reasons for purchasing commodities. Commodities can offer profit opportunities and diversify your investment portfolio. They are a type of asset, similar to stocks, bonds, cash equivalents, or real estate. Each asset class has unique characteristics, and investing in commodities can be an effective way to diversify your portfolio.
- Commodities don't always move in the same direction. For instance, when the stock market drops by 30%, some commodities like gold may remain stable or even increase in value. Investing in commodities with low correlation to other assets is an excellent strategy for portfolio diversification.
- Commodities also serve as a hedge against inflation. Inflation represents the rising cost of goods over time due to currency devaluation, and as inflation rises, commodity prices tend to follow. This is why commodities are often purchased during inflationary concerns.
- Commodities can also be traded for short-term profits. The commodity market is highly volatile, meaning prices can fluctuate significantly, allowing traders to capitalize on these movements for quick gains. This volatility stems from the ease of trading and speculating on commodities.
- Commodity investments can also act as a risk management tool. Hedging involves taking a position in futures contracts opposite to the physical commodity. For example, a farmer might buy wheat futures (the physical commodity) at planting time to lock in a price for delivery post-harvest. This protects against price fluctuations during the growing season. The buying position is called a long position, while the selling position is a short position, and these two positions offset each other.
Understand the risks of owning commodities. Commodities are considered high-risk assets due to their price volatility and the use of financial leverage compared to other investments. In a very short period, commodity prices can skyrocket or plummet.
- For example, between early June and early September 2015, crude oil prices dropped by 26%. However, by mid-September 2015, crude oil prices surged by 4.5% in a single day.
- Given such risks, commodity investors and traders are typically highly sophisticated and agile.
- One common way to invest in commodities is through futures contracts, which involve significant financial leverage (i.e., most of the investment is borrowed money). Leverage amplifies potential profits but also magnifies potential losses, making this method even riskier than non-leveraged commodity investments.
Purchase commodities through ETFs or mutual funds
Research what mutual funds and ETFs are. ETF stands for exchange-traded fund, which, along with mutual funds, are investment "baskets." When you buy a mutual fund or ETF, you're purchasing a collection of various investments, which may include commodity stocks, non-commodity securities, bonds, or commodities.
- With mutual funds, the investment basket is managed by a professional investor who actively monitors and adjusts the investments. You buy units in the fund, and their value fluctuates based on the performance of the basket.
- ETFs are similar to mutual funds, but many ETFs are passively managed, meaning they don't have an active manager buying and selling based on goals. Instead, ETFs typically track an index.
- An index in ETFs (like the Dow Jones or S&P 500) simply reflects the performance of a group of investments. For example, the S&P 500 includes the prices of the 500 largest companies in the U.S. When the S&P 500 rises by 10 points, it means the combined value of these companies has increased by $10.
- There are also commodity-specific indexes. For instance, a broad commodity index reflects the aggregate price of all commodities. A commodity ETF simply rises and falls with that index, as it holds the same commodities as the index.
Reevaluate the risks and benefits of commodity ETFs and mutual funds before purchasing. The primary advantage of buying commodities through ETFs or mutual funds is simplicity. These funds are traded like stocks and do not require you to physically own the commodities.
- ETFs and mutual funds allow you to own one, several, or all commodities in a basket, as there are numerous products available. For example, some ETFs hold all commodities, while others focus on specific ones like oil or gold.
- Investing in ETFs or mutual funds with diversified commodities can be less risky than funds holding a single commodity. If one commodity in the fund drops, others may rise, balancing the portfolio. Each commodity has unique supply and demand factors that influence its price. For instance, gold might rise in value during a trading session while potassium declines.
- The main risk of ETFs and mutual funds is that they still hold commodities, which are inherently volatile. While diversification reduces risk, there is always the possibility of partial or total loss of investment.
Open an online trading account. The first step to buying commodity ETFs or mutual funds is opening an online trading account. Many brokerage firms, such as TD Ameritrade, Capital One Investing, E*Trade, Charles Schwab, and TradeKing, offer this service.
- When selecting a brokerage, pay attention to fees, which are typically charged per trade and can range from $4.95 to $10.00. Visit Stockbrokers.com to compare brokers and their fees.
- Most brokerages require a minimum investment for commodity trading, often around $10,000. Confirm this with your broker. Many also require proof of investor experience before allowing futures and options trading.
- Most brokerages allow online registration, requiring only basic information and a transfer of funds from your bank account to the brokerage account.
- You can also download forms, fill them out, and submit them to the brokerage.
- Wait for the brokerage to approve your account.
Choose a mutual fund or ETF to purchase. Thousands of funds allow you to buy or sell commodities. To select the right fund, determine your goals. For example, do you want to diversify your portfolio by owning all commodities, or are you targeting profits from a specific commodity?
- If you seek a diversified fund, consider ETFs like the iShares S&P GSCI Commodity-Indexed Trust ETF or the PowerShares DB Commodity Index Tracking Fund. These funds hold multiple commodities and provide broad market exposure.
- If you want exposure to a single commodity, such as oil, visit etfdb.com for a list of ETFs focused on specific commodities. Alternatively, search Google using the commodity name and "ETF" to find relevant options.
Purchase the ETF or mutual fund. Once your brokerage account is open and you've selected your desired fund, you can proceed with the purchase. While the exact process varies by brokerage, the general steps are similar.
- Start by creating a new order. Enter the ETF symbol of the fund you wish to buy. You can search for the symbol on Google.
- After entering the symbol, specify the number of units you want to purchase. Determine this based on your investment amount. For example, if you want to invest $1,000 and the commodity is priced at $100 per unit, you can buy 10 units.
- Finally, click the "buy" button, and you will own the ETF units.
Purchase commodities through futures contracts
Learn about futures contracts. Futures contracts are the primary method for direct commodity trading, but they come with high risks and complexity. This method is mainly suited for advanced investors and traders.
- A futures contract is an agreement to buy or sell a predetermined quantity of a specific commodity at a set future date and price.
- These contracts are typically standardized. For example, a standard Brent Crude oil contract covers 1,000 barrels, while smaller contracts may cover 500 barrels.
- For instance, you could enter a contract to buy 1,000 barrels of crude oil at $40 per barrel on December 1, 2015. The contract's value would be $40,000 (1,000 x $40). If oil prices rise to $45 per barrel before December, your contract gains value because you can buy oil at $40 and sell it at $45, potentially earning a $5,000 profit.
Understand the risks before buying futures contracts. Futures contracts carry significant risks, which is why amateur traders should avoid them without thorough research.
- Futures contracts often involve margin trading, meaning you only pay a fraction of the contract's value upfront, with the rest borrowed. For example, you might pay 25% of the $40,000 oil contract value. If you sell the contract at $45,000, you could earn a 50% return on your initial $10,000 investment.
- However, this also means you could lose 50% or more of your initial investment quickly. If oil prices drop by $5 per barrel, your investment could halve. For instance, selling the contract at $35,000 after borrowing $30,000 would leave you with less than $5,000 after repayment.
- Note that margin requirements can exceed 25%, depending on the broker and investment type.
- Futures contracts also involve high commission fees and require strategic expertise.
Purchase futures contracts. If you're knowledgeable, you can use futures contracts to trade commodities of interest. To do so, you'll need a broker offering futures trading.
- Many brokers selling ETFs and mutual funds also offer futures trading, such as TD Ameritrade, E*Trade, and TradeStation.
- To buy a futures contract, select the commodity, expiration month, and number of contracts. For example, you might buy three December 2015 crude oil contracts at $38 per barrel.
- Most brokers provide dropdown menus for selecting commodities, dates, and quantities. Simply choose your options and click "buy."
Invest in commodities using futures options
Understand futures options. Futures options are a more complex investment method than futures contracts. While futures contracts obligate investors to buy or sell commodities, options provide the right (but not the obligation) to buy or sell futures contracts at a predetermined price.
- A call option allows investors to buy a futures contract at a set price, while a put option allows selling. The option price (strike price) is independent of the futures contract price.
- Due to their complexity, many financial advisors recommend that inexperienced investors avoid futures options entirely.
Explore the risks and benefits of futures options. Futures options are primarily used for two purposes: speculation and risk hedging. Both approaches come with potential rewards and significant risks.
- Speculating with futures options is similar to other securities trading but with a key difference. While traditional speculation bets on price increases, futures options require predicting whether a commodity's price will rise or fall relative to the option's strike price within a specific timeframe. This added complexity makes such speculation highly challenging.
- Unlike other investments, options have short lifespans, and most are never exercised. Investors only hold the right to buy or sell within a limited period, without owning the underlying asset.
- Risk hedging, the other use of futures options, is less risky. Essentially, it acts as insurance for your current investments. For example, buying a put option allows you to sell your investment at a predetermined price, minimizing losses if the asset's value drops unexpectedly.
Purchase futures options. If you decide to buy futures options, you can do so through your current broker. Many online brokers offer futures options trading, but ensure you meet any specific requirements they may have.
- While a put option requires selling a commodity contract, you don't need to own the contract to buy the option. Most call or put options are not exercised by the initial buyer, who instead sells the option before expiration to close the position, potentially incurring a loss or profit.
