Lesson 5: How to invest in Commodities

How to invest in Commodities

How to Invest in CommoditiesAfter to have seen in the previous article what the factors affecting Commodity price are, let's see now how to invest in commodities. There are different ways to make it:

Physical. The most obvious way to invest in commodities is by buying the physical good itself. By owning the commodity, we will have direct exposure to increases and decreases in its value, and we can sell the commodity when you want to convert it back to cash.

However, most physical commodities involve significant logistical problems. With commodities like gold or silver, it is relatively simple to find dealers to sell our coins or bars, albeit often at a slight markup. Instead, it is a lot harder to take possession of 1,000 barrels of crude or 5,000 bushels of soybean. Because of those problems, owning physical goods works well only in limited situations with specific commodities.

Futures. They are derivatives. That is, their value derives, precisely, from an index, a commodity, etc. which are linked, called underlying. Investing in commodities via futures offers to investors a way to get exposure to changing prices of commodities without having to take physical possession.

Using futures contracts, in fact, we will never go to possess a commodity on which we are going to invest. A futures contract is an agreement to buy or sell a certain amount of a commodity in the future, with an established price that can fluctuate with market conditions.

Spread Trading. With the spread trading, we go no more to work on a future, but on the difference between two or more correlated futures. We move from a directional operation with futures to a non-directional one with spread trading. This is a very important aspect.

With the spread trading, investors create a hedge of the position with a significant reduction of the risk. They get several other advantages that the trading with the futures cannot offer. I do not add anything else; you will see the spread trading in the next article.

ETCs. The Exchange Traded Commodity (ETC) gives investors the exposure on commodities in the form of shares. Traded like a stock, i.e. bought and sold on a stock exchange, ETCs track the price movement of commodities, such as oil, gold and silver, and then fluctuate in value based on those commodities.

ETCs can treat individual commodities or a commodity basket. An example of a commodity basket ETC is one that is composed of multiple metals (not only one), or a group of agricultural commodities, such as corn, wheat, and soybean.

Stocks. With the stocks, we are going to invest in shares of companies linked to the world of commodities. Mining companies and oil and gas exploration and production companies have direct exposure to commodities prices, and affiliated businesses, like heavy-equipment manufacturers and oilfield-services companies, tend to do better when the underlying commodities are performing well.

In this way, we will invest in companies who work an individual commodity, and this implies substantial differences. Often the price of a share of a company can undergo significant fluctuations due to external and economic factors. The price of a commodity cannot fall to zero, the price of a share can do it.

Options. They are contracts that give the holder the right to buy (call option) or sell (put option) a given quantity of an underlying financial asset (stock, future, Etf, etc.) at a specific price (the strike) and a date (or within a date). If I buy an option, I pay a premium; if I sell it, I get a premium.

Like the futures, also the options are derivatives. But unlike futures with whom we promised to fulfil the contract, when we buy the options, if we feel that the operation is no more convenient for us, we will not be obliged to fulfil the contract, and we will only lose the premium we paid previously.

For the second time during the reading of this chapter, you are probably wondering: among all these, which is the better way to trade commodities? You can, of course, use all the ways seen above. The best ones to trade commodities, for many good reasons, is through the spread trading and options. For options, I refer you to the relevant course for beginners, while regarding the spread trading, you will see it in the next article.

Seasonalgo, seasonal trading, spread trading, commodity market


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