Commodity Trading

Commodities are an interesting asset class right now for a number of reasons. Commodity investing is a good way to play both offense (global economic recovery) and defense (a hedge for your portfolio against rising future inflation and a falling dollar). They are also a great portfolio diversifier which can reduce the overall risk (volatility) of your portfolio.

Playing Offense: The global economic rebound is coming, and commodities will benefit.
Most of the economies in the world are currently in severe recessions or have significantly lower economic growth than 2 years ago. There are now many signs that the US economy and many other economies have bottomed out and are starting to show signs of life again. US economic growth has improved from a -6% rate over the winter to a -1% rate in the second quarter of 2009 and it will likely show positive economic growth in the second half of 2009. As the economies around the world go from serious recessions to positive economic growth over the next 2 years the demand for commodities will increase and their prices will go up. This global economic growth is likely to be led by China and many other emerging countries which tend to be commodity-based or commodity-heavy economies. China recently announced that their GDP growth in the first half of 2009 was 7.1%, putting them on pace to pass Japan as the world’s second largest economy by yearend. Investing in commodities is somewhat of a back-door play on emerging market growth.

Playing Defense #1: Commodities are a hedge against future inflation.
Historically commodities have been one of the best hedges against inflation. I am somewhat concerned about future inflation due to the massive monetary stimulus the US government has pushed over the past year. The monetary fire hose has been on full blast. Huge monetary stimulus has historically led to higher inflation 1-2 years later.

Playing Defense #2: Commodities are a hedge against a falling US dollar (for US investors).
Commodities are a good hedge against a falling dollar, which is another significant concern for many investors (including myself). Most major commodities (such as oil, gold, etc.) are priced in dollars around the world. When the US dollar gets weaker it has typically caused the price of commodities (in dollars) to go up. The US dollar has been weak for some time, and may continue to weaken going forward. A weaker dollar makes US citizens poorer relative to other countries. The US government’s massive “borrow and spend” fiscal stimulus plan has caused our budget deficit to balloon. This causes international investors to be increasingly concerned and to pull their money out of the US, pressuring the dollar downward.

Commodities are a good portfolio diversifier which can help reduce your overall portfolio risk.
One of the primary reasons investors add commodities to their portfolios is because they have historically had a low correlation with the returns of other investments such as stocks and bonds. This reduces the risk of your overall portfolio as the losses in some investments are offset by gains in others. At Longview Wealth Management we are always looking for investments that have an attractive risk/reward ratio on their own AND that have a low correlation of returns with other investments in our portfolios. Over the past 10 years (1998-2007) the correlation of returns between commodities and large US stocks has been only .14 and the correlation of returns with US bonds has been -.24. These are very low correlation ratios which indicate that commodities can provide powerful diversification benefits to your portfolio. Commodities can be volatile investments on their own but as a group can actually lower the risk of your overall portfolio over time if they are used properly.

What are the negatives of commodity investing?
1. Individual commodities are volatile and risky. For this reason commodities should represent only a small portion (15% or less) of most investor portfolios. We recommend a diversified basket approach to investing in commodities.
2. Investing in certain individual commodities can be difficult and complicated for many investors.
3. Commodity investments don’t pay interest or dividends to investors.

How to Play It? The Powershares DB Commodity Tracking Index ETF (DBC)
Based on my research one good way to get investment exposure to commodities in general is the Powershares Commodity Tracking Index (symbol DBC). This exchange traded fund (ETF) is one of the largest and most widely traded diversified commodity funds. It provides diversified exposure to the most widely traded commodities including crude oil (39% of the fund), heating oil (18%), gold (15%), wheat (15%), corn (13%), and aluminum (10% of the fund). The expense ratio on this fund is .75% which is below average for commodity funds.

This commodity ETF peaked in July of 2008 at around $45/share and then declined about 60% to its bottom of below $20/share in March of 2009. The commodity index seems to have been in a bottoming process over the past 6 months and has recently started showing signs of life bouncing back up to the current price of $22.50/share. This commodity index just broke through its 200 day moving average over the past couple of weeks on the upside. I think there is good upside from here over the long-term.

Author: Keith Tufte
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One of the most important decisions that an investor will make does not include purchasing an option or future; this decision is choosing a commodity broker. Understanding the dynamics involved in choosing a commodity broker is as much about understanding yourself as it is getting to know the commodity broker. Since commodity trading can be more involved than trading stocks, it is more important to select the right commodity broker than it is to select the right stock broker.

About Commodity Futures and Commodity Brokers

By definition, a commodity market is the location where sellers and buyers are about to conduct business in futures trading. A commodities trading contract is a legally binding agreement that defines an asset, the quantity of that asset to be delivered and the month when it will be delivered. A margin is invested to purchase the contract and the full balance of the contract is only required if the buyer takes delivery. If a commodity contract is purchased, the correct term is to “take delivery” and if a futures contract is sold, it is referred to as “making delivery.”

Commodity future contracts can be written for any type of commodity such as gold, lumber, livestock, currency, and many others. There are several different futures markets that handle specific types of commodities, such as the CME (Chicago Mercantile Exchange), NYBOT (New York Board of Trade), CBOT (Chicago Board of Trade) and others.

Futures exchanges are regulated by strict guidelines, both imposed by the government and internally, and they are require that trading is done “in the pit”, which means that transactions are handled by commodity brokers that are licensed and have paid to be in that position. These commodity brokers serve as the connection between buyers and sellers. Such an important link requires that you select someone that is not only an excellent commodity broker but someone that can identify your investment shortcomings and help to overcome those flaws.

Two Types of Commodity Brokers

There are two types, or levels, of commodity brokers and the level of service they provide is based on the needs of the investor: full service and discount. Each type of commodity broker has advantages and disadvantages that should be considered when making a decision.

Full Service Brokers

This type of commodity broker is usually recommended for new or inexperienced investors, or for those investors who invest in numerous markets. Full service commodity brokers usually provide more information, advice and help to their clients; they often work with investors to create personalized investment strategies. The fees charged by these commodity brokers are generally higher because of the extra level of service they provide. Full service brokers that specialize in trading commodities are also known as Introducing Brokers.

Discount Brokers

This type of commodity broker typically works better for more successful traders. Discount brokers can charge less for the services that they provide since they provide a smaller range of services.

How Do You Find the Right Commodity Broker?

Finding the best commodity broker for you is more a product of knowing your tendencies than anything else. Remember that your ultimate investment philosophy is to make money and your commodity broker’s job is to help you do that. Some of the traits that you should seek in your commodity broker are:

Experience

Chances are if your commodity broker doesn’t have much experience, the results you receive will be spotty at best. You don’t want your commodity broker to learn how to invest at your expense. Not only is experience in general important, but experience in the commodities where you want to trade.

Support

While a commodity broker may tell you about world-class support, what you get after you sign on is what’s important. If you are considering a particular commodity broker, call and ask for an explanation of the difference between bull call spread and a bear put spread; the level of response you get may be a good indication of the support you will receive after you open your commodity account.

Trial Period

Many commodity brokers will give you a free trial to “test drive” their service. Take advantage of this offer and see what happens. Remember that part of sampling something is trying to find out if it is good, no just trying to find out if it’s bad.

Conclusion

Choosing your commodity broker is one of the most important decisions you will make during your investing career. Successful trading can be the result or the victim of a commodity broker decision. Find a reputable broker that meets your needs and compensates for your shortcomings and you are on the road to investment success.

Author: Stephen Bigalow
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Investors in the United States are still very much embedded in a long-standing equity culture. They have become more sophisticated over the years, and conduct their own technical and fundamental research of specific stocks in order to make thought-out investment decisions. However, investors of all types are quickly seeking opportunities outside the equity realm as their confidence in their investment and trading skills continues to grow. Those investors are now turning to commodities in record numbers, and they’re using every possible financial instrument to gain exposure to physical commodity prices.

Commodities have been available to investors for decades, but why has their popularity grown so rapidly in recent years? The appeal is attributable to a variety of conditions, all of which will eventually make commodity trading as simple as buying and selling stocks, if it has not achieved that level simplicity to some degree already. Here’s why:

1. Well-known media outlets provide heavy coverage of commodity prices

2. Certain commodities are affected by geo-political risk and natural catastrophes, and are therefore newsworthy

3. Investors want to diversify their portfolios into non-equity asset classes

4. Data has become cheaply and readily available

5. Brokerage provide extensive research coverage

6. Online brokerage firms are expanding into futures with reduced commissions

What’s driving demand?

Investors continue to seek new opportunities beyond traditional equity offerings, but there have always been barriers to their participation in commodity markets. A general lack of understanding, inefficient access, and high agency costs for commodity investments have caused investors to look for opportunities in more traditional asset classes. However, those barriers are quickly disappearing, and commodity investments are beginning to be considered mainstream investments. Contributing to this effect are financial media outlets, the brokerage community, and growing concerns about current events.

Financial media outlets have become a source of information for retail investors, but have also become a source of entertainment. Some financial news channels may appear more professional than others, but they all have content that appeals to a wide range of viewers – from the novice investor to the sophisticated trader. Those media outlets help popularize commodities by focusing on spot prices, economic data, and exchange activity all throughout the day.

In addition to financial news reporting, media outlets provide continuous coverage of geo-political tension as well as natural catastrophes occurring all over the world. Investors can quickly gather detailed news about such events via the Web and television, allowing them to develop logical conclusions regarding the near-term impact on certain commodity prices. Those factors, combined with the underlying perception that emerging economies will require greater commodity consumption, will result in accentuated volatility in commodity prices.

Research coverage of commodities by major brokerage firms also helps promote commodities. Whether that coverage is in the form of equity-based sectors (i.e., stocks that derive their revenue primarily from activity in specific commodities) or in various instruments that provide exposure to commodity prices, investors are the target audience. Sell-side research is still very influential even after the Internet stock craze highlighted conflicts of interest. That is because such conflicts do not exist, or are not as apparent, in commodity markets.

Competition among brokers will also add to the promotion of commodities as investments. That competition will be based on their ability to provide customers with access to new investment opportunities, as well as tools that allow customers to make informed investment decisions. Commodity investment represents a new frontier for brokers because it allows them to expand beyond their traditional stock and bond offerings and into a complementary asset class. Brokers can expect to find a very receptive audience because investors are growing weary of stock performance.

How do we gauge demand?

Demand for commodities has become easier to quantify than ever before. It is exhibited through the success of “proxy” products, including mutual funds, equity index funds, equity index options, and commodity futures. Popular investments in the U.S. include the PIMCO Commodity RealReturn Strategy funds (symbol, PCRDX), the Energy Select Sector SPDR (symbol, XLE), StreetTRACKS Gold Shares (symbol, GLD), and more recently, commodity pools like the United States Oil Fund (USO). On the trading side, there are dozens of derivatives ranging from traditional commodity futures contracts, to options on equity indexes that track the performance of specific commodity sectors.

The PIMCO fund is a traditional mutual fund that passively tracks the performance of the Dow Jones AIG Commodity Total Return Index. The index covers the combined performance of a basket of commodities via their associated futures prices. The fund uses derivative instruments to gain direct exposure to that index. As of November 2008, the PIMCO funds had assets of over $7 billion since their inception about 4 years ago,(1) well off its highs of over $12 billion earlier this year when commodity prices were rising in unison, but still an impressive amount. As of November 2008, there were at least 132 commodity-focused mutual funds with total assets of over assets of over $35 billion.(2) While mutual funds are good places to invest, they do not address the needs of more active traders. That’s where Exchange-Traded-Funds (ETFs) and Exchange-Traded Notes (ETNs) come into play.

Partial List of Commodity-Focused Mutual Funds

Fund Name (symbol)_________________________Focus_________Net Assets ($, billion)____Inception Date

Vanguard Energy (VGENX)_____________________Energy________$4.97_________________5/23/84

PIMCO CommodityRealRet Strat Instl (PCRIX)______DJ-AIG Index___$3.88_________________6/28/02

T. Rowe Price New Era (PRNEX)________________Energy________$3.69_________________1/20/69

Vanguard Energy Adm (VGELX)_________________Energy________$3.37_________________11/12/01

Ivy Global Natural Resources A (IGNAX)___________Energy________$2.07_________________1/2/97

PIMCO CommodityRealRet Strat A (PCRAX)________DJ-AIG Index___$1.76_________________11/29/02

Vanguard Precious Metals and Mining (VGPMX)_____Metals________$1.69_________________5/23/84

Fidelity Select Energy (FSENX)__________________Energy________$1.58_________________7/14/81

Fidelity Select Energy Service (FSESX)____________Energy________$1.01_________________12/16/85

RS Global Natural Resources (RSNRX)___________Energy________$0.92_________________11/15/95

Source: fund sponsor’s websites and Yahoo! Finance, data as of October 31, 2008

Until recently, the only way for most individual and institutional investors to quickly access the commodities markets was to purchase stocks that focused on specific commodity sectors. That strategy was made much more efficient with the arrival of ETFs, which hold baskets of stocks in specific sectors. Low brokerage commissions, abundant liquidity, and all the efficiencies of an electronically traded product helped ETFs gain in popularity as both investable and tradable instruments. Even so, the funds are less than perfect proxies for commodities because they still carry the corporate risk of stocks they hold. The companies in a fund may also be engaging in hedging activity that dampens the correlation between their stock price returns and the commodities they produce. This paved the way for a new breed of exchange-traded instrument; one that attempts to securitize commodity prices and which is still available through ordinary stock brokerage accounts.

The StreetTRACKS Gold Trust, often referred to as the “Gold ETF,” is a trust that primarily owns gold bullion. This is one of the best examples of how Wall Street is repackaging commodities into equity-like instruments. The investment objective of this trust is to issue shares that reflect the price performance of gold. The shares trade under the ticker symbol GLD on the New York Stock Exchange. The trust was launched in November 2004 by the World Gold Council, and by October 2008, it had net assets of about $17.6 billion.(3) But that is just one of a new stream of exchange-traded trusts and funds. Over the past year, Deutsche Bank, Barclays, and others have begun to roll out products in the energy sector as well as other metals. Even agricultural commodities such as corn and wheat are available to trade as stocks in regular brokerage accounts. Currently, there are at least 130 ETFs, trusts, and ETNs that track commodity price performance by way of holding stocks that produce those commodities, physical commodities, or futures contracts.(4) As of October 2008, those products represented almost $50 billion in assets.(5) Similar to the commodity-focused mutual funds, AUM levels for those products have also declined, not only because of redemptions in the funds but because certain commodity prices have plummeted. Even so, the sharp spike in asset growth up until mid-year underscores investors’ interest in the asset class as well acceptance of fairly new instruments like ETNs.

Partial List of Commodity-Focused ETFs, ETNs & Trusts

Fund Name (symbol)___________________Focus________Fund’s Holdings____Net Assets ($, billion)____Inception Date

streetTRACKS Gold Shares (GLD)_________Gold_________Phys. gold________$17.60________________11/18/04

Energy Select Sector SPDR (XLE)__________Energy_______Energy stocks_____$5.13_________________12/22/98

iShares Silver Trust (SLV)________________Silver________Phys. silver________$2.01_________________4/21/06

Oil Services HOLDRs (OIH)______________Energy Oil_____Stocks___________$1.86__________________2/6/01

iPath DJ-AIG Commodity Index (DJP)_______Mixed________Derivatives________$1.85__________________6/6/06

iShares COMEX Gold Trust (IAU)__________Gold_________Phys. gold_________$1.49__________________1/21/05

PowerShares DB Commodity Fund (DBC)___Mixed________Derivatives_________$1.26__________________2/3/06

PowerShares DB Agriculture Fund (DBA)____Ags__________Derivatives_________$1.17_________________1/5/07

United States Oil Fund (USO)_____________Energy_______Derivatives_________$0.80_________________4/10/06

United States Natural Gas Fund (UNG)_____Energy________Derivatives_________$0.79_________________4/18/07

Source: fund sponsor’s websites as of October 31, 2008 or later

Securitized exposure to commodity prices is not unique to the U.S. To be sure, the London Stock Exchange (6) currently lists over 120 Exchange Traded Commodities while Deutsche Brse lists over 110 such products.(7) Every major stock exchange now lists some form of open-ended fund-like instrument.

In addition to the various funds and trusts available to investors, US options exchanges further expand the menu of choices by offering cash-settled options on indexes that focus on specific commodity sectors. From the Philadelphia Stock Exchange’s PHLX Oil Services Index (symbol, OSX) to the International Securities Exchange’s ISE-Revere Natural Gas Index (symbol, FUM), investors have additional flexibility to execute complex spreads quickly and cheaply. Although options now exist on some of the trusts and commodity pools listed above, cash-settled options on indexes themselves offer additional flexibility in how investors tailor their exposure to commodity price movements.(8) For example, an investor employing a strategy that involves selling in-the-money options will not have its position altered by being assigned. Rather, the European-style exercise of those index options will ensure that the position remains intact.

While there may be dozens of commodity-based funds and index options listed on exchanges over the next few years, let’s not forget old-fashioned futures – the instrument of choice among hedge funds all over the world, as well as the core holding of many of the new commodity-based ETFs. Energy futures products have gotten a much needed facelift over the past three years, largely due to the demand from hedge funds as well as retail investors. That demand has futures exchanges scrambling to compete for those new customers.

In 2003, the New York Mercantile Exchange (NYMEX) began offering reduced-value versions of its energy futures contracts in an effort to target smaller investors. The contracts were branded “miNY” to capitalize on the popularity of reduced-value index futures called “E-mini”.(9) In order to further capitalize on the burgeoning retail interest, NYMEX made the products available on the Chicago Mercantile Exchange’s (CME) GLOBEX platform so that they may be traded electronically – well before its acquisition by the CME. Here’s where the competition kicked into high gear.

In early 2005, the InterContinental Exchange (ICE) fired the first direct shot with its electronically-traded, and cash-settled WTI crude oil contract – the flagship benchmark of NYMEX. The listing of that product was in addition to its own crude oil benchmark, Brent crude, which was already an actively traded contract in Europe. Volume in the ICE’s Brent contract is currently about 175,000 contracts per day while its WTI contract trades almost 283,000 contracts per day year-to-date.(10)

NYMEX responded, albeit slowly, by listing its full-size products on GLOBEX. Since their initial listing on CME, trading in the energy complex has grown from just under 100,000 contracts per day on average to currently about 550,000 contracts per day year-to-date.(11) However, trading in its Brent contract is virtually non-existent.

How can you practice trading?

Unfortunately, there are no “do overs” in your brokerage account, so where can you test your commodity trading strategies online? Investors may want to visit a “virtual trading” website to test trading strategies with real market data before putting real money at risk. Some virtual trading websites combine the functionality of a brokerage platform with order matching logic of an exchange. Traders can go long or short and accumulate virtual dollars. Traders can also hone their skills by competing with others in contests. In sum, virtual trading websites combine simulated trading and real entertainment to create a unique educational tool.

What happens next?

The number of investment vehicles and tradable instruments is truly astonishing, and there is no sign of slowing down. Investors can expect to see new products proliferate through the entire commodity spectrum, and a quick review of prospectuses on the SEC website already reveals many new products just waiting for regulatory approval. But that seems like only the tip of the iceberg when one considers the pipeline of new ideas being developed by investment firms of all sizes. So while you will have a hundred ways to trade crude and natural gas, all you fans of the movie “Trading Places” can take solace in that it won’t be long before you can trade frozen concentrated orange juice – just as you would in any stock or index fund. In the meantime, check out a virtual trading site to get your feet wet in the virtual commodity pits before you start putting your real money to work.

Notes:

(1) See fund profile at the Alliance site.

(2) See fund summaries at the website of Lipperweb.

(3) See data from website of State Street’s Streettracks’ goldShares. State Street is the marketing agent for the fund.

(4) From fund sponsor’s websites.

(5) From fund sponsor’s websites.

(6) From the website of the London Stock Exchange

(7) From the website of Deutsche Borse

(8) Options on the streetTracks Gold Shares, GLD, were only available on options exchanges earlier this year in 2008 after the SEC and CFTC came to an agreement to allow trading in the products. However, at the time this paper was written, options trading on the iShares Silver Trust, SLV, as well as another gold trust, have yet to be permitted.

(9) “E-mini” is the name of a reduced-value futures contract branded by the Chicago Mercantile Exchange (CME); it was created to appeal to smaller investors, to be traded electronically as opposed to manually on an exchange floor.

(10) Statistics for ICE energy contracts are shown at the website of the Intercontinential Exchange.

(11) Statistics for NYMEX energy contracts are shown at the website of the New York Mercantile Exchange.

Author: Kris Monaco
Article Source: EzineArticles.com
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