How to Invest in Commodities as a Beginner Investor
If you have been wondering how to invest in commodities or flirting with the idea of diversifying your portfolio by moving into this area of investing, you’re in the right place.
Commodities have somewhat of a bad boy reputation in the world of investing, with many steering clear of them altogether for fear of losing money due to the volatility of commodities prices and the mind-boggling leverage available on futures contracts.
Yet this reputation is largely undeserved. If you play smart and put proper risk management strategies in place, investing in commodities can be as safe as any other security, and can be extremely lucrative into the bargain.
What are Commodities?
Commodities, to put it simply, are real things which we can pick up with our two hands and use in the world.
From the grains which make up your breakfast cereal, to the silver and copper inside your computer, to the crude oil that is refined into the petroleum you use to drive your vehicle, commodities are many things, but what they all have in common is they are physical in nature and traded on the world markets.
Some of the most popular commodities for investors are:
- Oil
- Gold
- Silver
- Natural Gas
- Grains
- Coffee
- Sugar
There are many other commodities bought and sold on world markets. In this quick guide, we will look at how to invest in commodities as a beginner.
Who Should Invest in Commodities?
If you are completely new to the world of investing, we recommend taking a step back and mastering the basics of stock investing first.
Commodities can be a risky game if you don’t know what you are doing, and it will be much more profitable long-term to get a grip on the basics first then proceed to commodities later.
If you have a firm grip on stock investing but have limited capital to invest, then it is best to approach commodities through ETFs.
These funds are a back door into the commodity markets, and allow you to buy and sell commodities just as you would stock and shares. If you choose not to invest through ETFs, you will need to use more exotic instruments like futures contracts, which require in-depth commodities knowledge.
On the whole, commodities are best suited to investors with a large chunk of capital to spare and it is best to manage risk by making commodities a part of a balanced portfolio, rather than putting all your eggs in one basket, so to speak.
So, anyone can invest in commodities, but they are best suited to investors with larger amounts of capital and at least some experience.
Commodities Investing Choices
When it comes time to put your hard earned dollars into commodities, you have the following choices.
$CRB-Thomson Reuters/Jefferies CRB Index
(All Commodities)
If you like the idea of investing in a fund which covers all commodities, rather than picking an individual commodity and focusing on it, then this is a great way to go.
The obvious advantage here is diversity.
Commodities prices can climb and dive sharply, and if you have all your money in one type, you might be shocked to find that suddenly, without warning, you lose all your gains.
The flip side, of course, is that you could also make a lot of money quickly by focusing on just one commodity and getting in at the right time, whereas a mixed fund like this will take longer to grow and returns will be much more stable.
$GKX- Agricultural
This is a subgroup of the Goldman Sachs Commodities Index which includes a broad range of agricultural commodities.
Grains, coffee, sugar, cotton, cocoa, and even orange juice are included in this index.
$GJX- Energy
This index focuses on the world’s energy markets and includes crude oil, natural gas, and heating oil.
It is, again, a subgroup of the Goldman Sachs Commodities Index.
$GYX- Industrial Metals
Not to be confused with the precious metals index, which covers gold, silver, and platinum, this index tracks the industrial metals of the world - those found in everything from cars to blenders - including steel, copper, and nickel, to name a few.
If the overall manufacturing sector is doing well, there is a good chance the demand for, and thus prices of, this fund will be up.
$GVX- Livestock
Lean hogs, feeder cattle, and live cattle all make up this index.
It takes a while to learn what drives this index up and down, but weather, global demand, and other cyclical factors move the price up and down.
$GPX- Precious Metals
This index is made up of the precious metals gold, silver, platinum, and some others.
These are typically much higher value metals than the industrial ones. Many investors choose to buy these metals and physically keep them in storage. Gold prices, in particular, move up when the stock market is struggling as investors see it as a ‘safe haven’.
Futures Contracts
Futures contracts are one way to get into commodities investing.
In essence, you are agreeing to buy x amount of a given commodity at a specific date in the future.
For example, you might agree to buy 10 tons of coffee 30 days from the date you place the trade. You are hoping that there is a significant enough difference in price by then so that you will make a profit.
To illustrate further, imagine you agree to buy the 10 tons of coffee 30 days from now at the current market price of $1670 per ton.
If you lock in the future contract at that price, and in 30 days the price is $2000 per ton, you will be buying at a bargain price and will be able to quickly sell on your coffee for a profit, well before you ever have to take delivery.
That is how futures contracts work in a nutshell. Don’t forget, however, that the reverse is equally true, and if the price at a later date is less than it is when you buy, you will potentially lose money.
Commodity ETFs
ETFs are exchange traded funds, and as we hinted at earlier, they allow you to trade commodities in a similar way to stocks and shares.
An ETF is essentially a giant fund, and you can buy shares in that fund, just as you would in a company.
Commodities ETFs reflect the price of whatever commodity (or combination) the fund is made up of.
For example, the iShares Silver Trust reflects the price of silver, and each share in the fund will be the price of one ounce of silver. Naturally, you want to buy low and sell high if this is your chosen commodities trading vehicle.
Trading ETFs is a great way to get exposure to the commodities market with less risk, since you can hold your ETF shares for as long as you want, and they don’t expire after a set period of time, like futures contracts and options.
Do be aware of some of the fees associated with trading ETFs. Ask your broker if they offer fee-free ETF trading before investing.
Commodity Index Funds
Another, indirect way of getting involved in commodities trading is to invest in the companies which are involved in commodities production.
For example, investing in British Petroleum is a way to get involved in the oil business, and investing in Rio Tinto is a way to get involved in all manner of metals since this firm mines just about everything it is possible to mine.
Commodities Investing Pros and Cons
Like every way to invest, there are pros and cons to commodities investing. Some of them are as follows:
Pros
- POTENTIALLY HUGE RETURNS - Lots of commodities traders have made fortunes overnight, and even if you never become the next commodities trading multi-millionaire, commodities return a high return during bull markets.
- ADDED DIVERSIFICATION - Commodities are a great way to diversify your portfolio. Add them to any current mix and you will have exposure to one of the most exciting and lucrative types of security out there.
- INFLATION HEDGE - While money can be inflated away year after year by central banks printing more of it, commodities are much harder to come by and thus have inherent worth which is difficult to chip away at. Yes, commodities prices do fluctuate, but no matter what price level they are currently trading at, they offer a good hedge against inflation, particularly in this era of ‘helicopter money’.
- LOWER MARGIN - You can trade commodities on lower margin than many other securities. It is possible to leverage yourself almost 100:1 in the commodities market, not that we recommend that. However, you don’t have to take that level of margin, and you can get started trading commodities on margin with as little as $10,000.
- TRANSPARENCY - You can see the price of nearly all commodities daily, and unlike with many companies and index funds, commodities prices are determined by simple supply and demand. Nobody can cover anything up, there is no fiddling with the books, and nobody has exclusive ownership over the commodities markets. It is all there for everyone to see, and that makes commodities one of the most transparent markets to invest in.
Cons
- HIGHLY VOLATILE - Commodities investing isn’t for the faint at heart. You can quite easily ‘lose your shirt’ trading commodities if you don’t use proper risk management, due to the highly volatile nature of the commodities markets. War, weather, geopolitics, and all manner of other factors affect prices, often in rapid, unexpected ways. You need to keep your eye on the ball, and you need to be prepared for the inevitable volatility, especially if you are trading on margin.
- NO EARNINGS/DIVIDENDS - Unlike investing in stocks and shares, there are no quarterly dividends or company earnings to rely on. You are fully reliant on the buy low/sell high model of money making when you trade commodities. It is the only factor involved, and this lack of any fixed income or return puts many investors off.
- HIGH COSTS - The costs associated with commodities investing can be on the high side. This isn’t always the case, but the costs will almost certainly be higher than investing in stocks. Management costs, early termination of contract fees, and costs associated with trading on margin can all add up and eat into your profits. Make sure you work these out in advance before trading.
- NEGATIVE REAL RETURNS - If you hold the commodity for a long time, you might find that inflation renders your returns negative over time. This is called ‘negative real return’ and this happens when the value of the money you are selling the commodity for has been degraded while you have been holding the contract or slice of the fund. Some other factors can play a part, such as dips in the value of the commodity, causing you to sell at a loss before you planned to.
- LOSS OF VALUE - Nothing is guaranteed in the commodities game, and something that is worth double what you bought it for today could be worth next to nothing just a few days later. Commodities markets fluctuate like no other, and you have to be prepared for long price slumps when they come. That’s just one of the built-in risks associated with this type of trading, and there are no 100% accurate ways to predict when prices are going to move south, although some reasonably accurate models do exist.
How to Invest in Commodities -
3 Steps & Some Tips
- 1 - The very first thing you need to do before getting involved in commodities is to choose your investment method. There are pros and cons to futures contracts, ETFs and index investing, and it is up to you to figure out which one you would like to use. For total beginners, we recommend ETFs as they are generally safest.
- 2 - The next step is to research the commodities you want to invest in. You might choose to focus exclusively on one, such as gold or corn, or you might decide to trade a mixed blend of commodities, either as part of a fund or individually at the same time. Stick with what intuitively makes sense to you to begin, and leave the rest until later.
- 3 - Learn the fundamentals of what makes commodities prices move. If you watch for a while, it won’t be long before it clicks and you realize that supply and demand is by far the biggest factor in the market.
The real key to mastering a commodity, however, is discovering what affects supply and demand.
For example, demand for pork bellies skyrockets around Chinese New Year, since this is a food consumed in vast quantities at celebrations in China, which has a colossal population.
Another example is what happens to the price of oil when trouble flares up in the Middle East, particularly when Iran might be involved, since most of the world’s oil supply travels through the Straight of Hormuz, which Iran controls. If investors panic that supply might be affected, this causes a buying spree.
You will learn to spot these patterns, many of which are cyclical in nature.
Once you are fairly confident you have at least a basic grip on what causes the prices of the commodity in question to move up or down, it is time to tie all the elements of this plan together and begin trading.
As far as tips go, there are three main ones to focus on:
1 - Storing commodities can be a good option.
You might find that actually buying physical commodities and storing them is a good way to go. This can definitely be the case when it comes to precious metals, for instance.
However, it is not such a good idea when it comes to storing tons of something perishable, such as corn or grains. In this case, the management fees associated with doing so, and the perishable nature of the commodities, might make it impractical to take physical delivery.
If you do decide to invest in precious metals, you can use remote gold dealing and storage.
Always do your research about potential fees when using these sorts of options.
2 - Don’t invest too much of your capital in commodities.
It is generally advisable to limit your exposure to 5-10% in total, making commodities a part of a larger investment strategy rather than your sole focus.
3 - Don’t over-leverage yourself.
While the idea of trading on margin is attractive since lots of money can be made quickly, the opposite is also true. Trading on margin can see your own capital dry up in an instant, prompting a margin call which if you are unable to meet, will mean trade is closed and you will lose money.
Recap
Commodities can be seductive, with their promise of potentially lucrative returns and the many stories of instant wealth made in the commodities markets.
Like all things seductive, it is wise to approach commodities with caution, and realize that jumping in before you are ready and thinking clearly could be a costly mistake.
That said, if you make sure you fully understand what you are doing, develop a strategy with an exit plan built in, and never get in over your head, commodities can make for a great addition to your portfolio!