Updated on March 30, 2023
Commodities are becoming increasingly popular because of their reputation as an excellent hedge against inflation, but you’re probably wondering what commodity-buying strategies offer the highest benefit. This article breaks down the various strategies employed by seasoned investors to add commodities to their portfolios.
Commodities are raw materials used in the production of goods. They are divided into hard and soft categories. Hard commodities are mined from the earth and include examples such as gold, silver, platinum, etc. On the other hand, soft commodities refer to agricultural products or livestock like corn, wheat, coffee, sugar, and others.
There are three main ways investors get into trading commodities: owning the physical commodity, buying futures contracts, or investing through a mutual fund or ETF. In other words, an investor can choose to hold physical gold coins, trade a gold futures contract, and invest in mutual funds or ETFs that focus on gold.
Although this might seem like the most obvious route to take for investors interested in buying commodities, it is cumbersome. With physical ownership, you have to plan and account for storage, spoilage (for soft commodities), insurance, and liquidity of the tangible commodity. For instance, suppose you purchase 3,000 bushels of corn as a strategy to diversify your portfolio and hedge against inflation. You’d need a barn to store the corn. You’d also need insurance against potential loss from fire, pests, etc.
Supposing you decided to sell your corn, you would still need to find a buyer and at your desired price. This would be especially difficult if you are not a farmer with access to the right connections. Now imagine this situation multiplied across your entire portfolio of commodities! This would be intensely stressful and possibly the least effective way of getting into commodity trading.
This method is much easier and less time-consuming than holding physical commodities. Futures contracts make it possible to invest in a particular commodity at a minimal cost. A futures contract is an agreement between two parties to exchange an asset at a specific price and quantity, and date.
Futures contracts are standardized and traded on the Chicago Mercantile Exchange (CME). For instance, 1 corn futures contract is equivalent to 5,000 bushels of corn. Similarly, 1 coffee contract holds roughly 37,500 pounds of coffee. Using our earlier corn example, you would typically buy 1 corn futures contract on the CME to hedge against rising food prices. Supposing the corn prices rise, your futures contract would increase in value and vice versa.
At the expiration of the contract term, you would be required to take possession of the underlying commodity. Alternatively, you could take an offsetting position to your futures contract. Trading futures is highly speculative and sophisticated, which is why it’s only recommended for the most confident and advanced investors.
Mutual Funds and ETFs
These cannot be used to directly invest in commodities. However, investors take part by investing in stocks of companies involved in commodity-related industries like mining, energy, or agriculture. Similar to the underlying assets they invest in, shares of mutual funds of ETFs can be affected by factors that aren’t industry specific.
They are undeniably the best paths an average investor can use to gain exposure to a broad group of commodities without encountering the risks mentioned in physically owning each individual commodity or buying a futures contract. Investors can easily trade mutual funds and ETFs which adds to their wide appeal.
Investing in mutual funds and ETFs allows investors to benefit from professional management services, increased diversification, and liquidity. However, some mutual funds carry high management fees and separate tax obligations.
Consequently, investors ought to carefully review the structure of their mutual fund or ETF before deciding on whether to invest or not.
Regardless of which avenue you take to get into the commodity market, there’re a few basic strategies you can use. Let’s explore some strategies you could utilise in selecting which commodities to invest in.
Find your market
Successful commodity traders typically specialize in trading either a single market, like gold, or a small segment within that market. Finding your market isn’t just about deciding on a single commodity to focus on. It is also about placing emphasis on a market you inherently understand or at least have passion for.
For example, a simple review of your trades over a six-month period would give you a great indication of where your strengths lay. As you continue trading, you’ll also inevitably develop a sense of which markets you feel more confident about. Should you find that trading oil futures come easily to you, then that’s what you should focus on.
Interestingly, even large institutions like banks practice this strategy. Rarely will they use the same person for both gold and cotton trades. They typically assign a particular trader or team to execute trades on one segment of the futures market, such as energy futures.
Watch the prices
Historical data reveals that prices, despite the occasional price volatility brought on by macroeconomic events, typically experience periods where high demand and short supply force market prices higher or when the reverse is true.
Therefore, investors are wise to look for price trends using charts that track data daily, weekly, or monthly. Seasoned commodity traders will often talk about moments in which they witnessed the price of a commodity go from limit-up to limit-down and then back again. With the ability to recognize patterns and trends, it is possible to make gains in any given situation.
Understand the global forces
Commodity trading is highly susceptible to macroeconomic forces. Therefore, commodity traders should be aware of what’s happening not just in their geographical location but also in the world. For instance, the Russian invasion of Ukraine sent shockwaves to many different commodity markets, not just in the U.S. but also in other countries across the globe. Those investors paying attention as the situation unfolded were able to adjust their portfolios and prevent losses.
When it comes to commodity buying strategies, novice and experienced traders can participate in the market, given that they have a firm grasp on what works for them and what doesn’t. There isn’t a silver bullet strategy that can guarantee continuous wins, but investors can set themselves up for a win by finding their market, watching prices, and understanding macroeconomic forces.
What are the different ways to invest in commodities?
The three main ways to invest in commodities include owning the physical commodity, buying futures contracts, or investing through a mutual fund or ETF. Each has its own advantages and disadvantages, so investors should consider their own risk-reward profile before deciding which route to go.
What are the pros and cons of physically owning a commodity vs. investing in a mutual fund or ETF
The pros of physically owning a commodity include the ability to hold a tangible asset, and the potential to gain from price fluctuations. However, the cons include the cost of storage, spoilage, insurance, and liquidity. Investing in a mutual fund or ETF is less cumbersome, as it involves minimal cost and allows for diversification and liquidity. However, there may be high management fees, and separate tax obligations.
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