Lesson 8: How to invest in commodity markets

In yesterday’s lesson you learnt more about the market for soybeans and why they are likely to become increasingly important as emerging economies adopt more Western style, high protein diets.

Today’s lesson aims to take everything you have learnt over the past seven lessons and will show you the basics of how you can trade or invest in commodity markets.

Buy and hold physical commodities

Historically, many people have sought to hold a commodity in physical form, either as an investment or as a store of value. The commodity that has traditionally held this role has been gold, but also other precious metals like silver.

Holding a commodity in physical form has its downsides though, its security namely, but also the lack of a ready market to sell it in the event that you want your money back. Nowadays, the purchase of precious metals tends to be on deposit at a bank so that they can store it on your behalf, for a charge of course.

Exchange Traded Products

While it’s feasible for a private investor to be able to buy and hold a precious metal, it’s a lot more difficult to purchase a barrel of crude oil or a tonne of soybeans! This is where products based on the underlying physical or futures market can help.

Futures-based exchange-traded products (ETPs) use futures contracts to provide exposure without any physical holdings. However, investors should note that the return may not be the same as the spot price.

For example, when near term prices are higher than future ones (a condition known as backwardation), the ETP investor gains when the positions are rolled over when the contract expires. However, when the market is in contango an investor’s returns will be eroded.

Equities of commodity producers

Investing directly in companies involved with energy, mining or agriculture is another way of gaining exposure to one or a basket of different commodities. Note that the equity prices of commodity producers are not always correlated with the price of the underlying commodity.

Factors such as capital expenditure, government policies, management, balance sheet and accounting practices, unforeseen operational issues (a miners’ strike, for example) and the general appetite amongst investors can all affect the share price.

Going short?

Contract for differences (CFDs) and spread betting offer a way for investors to bet on the direction of particular commodities, either up or down. In addition they enable speculators to place a position using leverage, meaning you only need to put down a fraction of the capital outlay.

Let’s take a look at how a spread bet works. Say you take the view that the price of cocoa is going to rise because of civil unrest in West Africa, the spread betting company might quote a price of $2,350–$2,375 per tonne in the daily futures market. The bid price on the left being the price you can sell at and the offer price, on the right side being the price you can buy at.

You decide to bet $10 a point (in this example each $1 is a point) at $2,375 in the expectation that prices will go up. The price quickly rises to $2,475–$2,500 and you decide to sell at $2,475, netting $1,000 (100 points x $10).

There are serious risks involved with CFDs and spread betting because the contract is two-way. Just as the spread betting provider will pay you if you call the commodity price movement correctly, so you will have to pay out if you get it wrong. And just as leverage magnifies your profits, so it also magnifies losses.

I hope you found this lesson on how to invest in commodity markets interesting. Some of the pitfalls to watch out for, both emotional and market related will be discussed in lesson 10.

Up until now we have focused on the fundamentals of the commodity markets (ie, demand and supply), but in the next lesson we will focus on how you can use technical and positional analysis to your advantage.

Go to lesson 9