How to invest in Commodities
Commodities are classed as physical assets and include metals such as gold, silver, platinum and copper, oil and gas, and also ‘soft’ commodities such as wheat, sugar, cocoa beans and coffee. Often referred to as the fifth asset class as they differ from conventional investment asset classes of cash, fixed interest debentures, equities and property.
Commodities play an important part in everyday life and with little correlation with the stock market and currencies, are useful for the purpose of diversification within investment portfolios.
Traditionally, most people did not know how to invest in commodities as doing so required large amounts of capital, time and expertise. These days there are a number of different methods to the commodity market making it easy for the average investor to participate.
There are typically four ways to invest in commodities – either directly by buying it physically, or buying shares in commodity companies, or indirectly through funds or investment trusts and through the use of futures.
Recently this has become a very popular way to invest in commodities. A futures contract is an agreement to buy or sell, in the future, a specific quantity of a commodity at a specific price. Futures are available on all commodities such as crude oil, gold, natural gas, as well as agricultural products such as cattle or corn.
Many of the participants are actual commercial or, in some cases, institutional users of the commodities they are trading. The remaining participants, which in most cases, are individuals, are traders who hope to profit from the changes in the price of the futures contract. Positions from these individuals are typically closed out before the contract is due and never take physical delivery of the commodity.
The first step to investing in a futures contract requires opening a brokerage account and completing the subsequent forms acknowledging that the risks are understood.
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.
Future contracts will also have options associated with them. Options are derivatives and help limit the loss to the cost of options.
It’s the purest form of commodity purchase
Leverage allows for huge profit if on correct side of trade
Long or short can be chosen easily.
The minimum-deposit accounts allow control over full-size contracts which typically would not normally be affordable.
Futures are very volatile and direct investment into these carries a considerable risk. Not suitable for an inexperienced investor.
Leverage magnifies the gains but also the losses
A trade can go against you very quickly and the risk of losing your deposit and more is very real.
Stocks & Shares
Many investors looking for commodities play use stocks, which are a lot less volatile than the futures market. When investing in stocks, research has to be undertaken into the company as well as the underlying commodity.
Gold companies allow investors to invest in mining equipment, drillers, retail companies or diversified gold companies. The stocks are easy to buy, hold, track and ultimately trade and sector can be chosen.
Trading is easier as investors usually have a brokerage account setup
Stocks are usually highly liquid
Public information on companies is readily available
Stock prices are not a direct result of the underlying commodity
Prices may fluctuate due to company specifics as well as market specifics
Exchange Traded Funds and Exchange Traded Notes
Exchange traded funds (ETFs) and exchange traded notes (ETNs), trade like stocks, and 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.
Because they trade like stocks, there are no management fees and thus provide an easy way to participate in commodity investment
A big move in the commodity may not be reflected in the ETF or ETN
ETNs have credit risk associated with the issuer