Investing and speculating is easier today than back in the day when you had to buy a sacks of rice or barrels full of salted fish and then store them in your home for a long time, hoping for the price to creep up.
Today, you don’t have to take or make delivery of actual commodities to make money from price fluctuations on commodity markets. Instead, you can trade in derivatives such as options and Contracts for difference (CFD) certificates where a commodity – such as sugar, silver or pork bellies – is the underlying asset. We can also easily buy CFD:s, shares or stock options from the comfort of our own homes, or pool our money with others in mutual funds and similar. This is just a few examples of possible investment opportunities.
Below, we will take a look at a few examples that may be of interested for potential investors and traders.
Shares in stock companies
For informally about investing in stock companies, please visit our article “Investing in shares” on this site.
A stock option will give its owner the right, but not the obligation, to carry out the stipulated transaction. If you own a call stock option, you have the right to buy the shares on a certain date or dates, or within a pre-determined period of time (depending on the type of stock option). The opposite – a stock option that gives you the right to sell shares – is called a put option.
If you don’t want to invest directly in a commodity company, trading in stock options can be a great alternative. Since there are both call options and put options, you can invest even if you believe that the stock price will be going down. Trading in options is much safer than selling shares short to benefit from dropping share prices.
Another reason why some investors opt for stock options instead of stock is that some stock companies have very high priced shares. Buying even one single share can be prohibitively expensive for the hobby investor, and it also makes it more difficult to diversify the investment portfolio.
As always, it important to not assume that option price movements will perfectly mirror the share price movements. Owning shares and owning stock options are two different things.
One of the oldest types of futures contracts is the commodity futures contract. This is a standardized commodity forward contract, and the standardization makes it highly suitable for trading.
The producer of a commodity agrees to sell a specific amount of the commodity at a specific date in the future for a pre-determined price. The buyer of the commodity agrees to pay the pre-determined price on the pre-determined date in exchange for the pre-determined amount of the commodity. Together, the enter into a forward contracts. Unlike an options contract, both parties are obliged to carry out the transaction stipulated in the forward contract.
The birth of the futures contract
Forward contracts arose chiefly because farmers (sellers of agricultural commodities) and companies that needed such commodities for their business both wanted to be able to plan their economy. Instead of having to wait and see whatever the price for wheat, coffee or sugar would be in the future, they wanted to lock in the price today. Eventuality, trading with forward contracts by third-party speculators gave rise to the futures contract. While forward contracts are drawn up by the commodity seller and the commodity buyer to suit their specific needs and preferences, futures contracts are highly standardized and thus more suitable for trading among third-parties who doesn’t have to read through all the details of each individual contract before they make a trade.
Forward contracts and futures contracts are not just available with agricultural commodities as the underlying asset. If you want to invest in commodities, you can for instance buy futures contracts where the underlying is a metal (gold, silver, zinc, palladium, steel, etc) or an energy resource (crude oil, natural gas, kerosene, etc).
Options contracts associated with futures contracts
It is not unusual for futures contracts to have options contracts associated with them; options that can be bought and sold independently of the futures contracts. As a trader, it is important to remember that although the market price of the option tend to be linked to the market price of the futures contract, the two price movements can not be expected to always mirror each other perfectly.
Commodity Pool Operation
A commodity pool operation (CPO) consists of pooled money from several investors. The pooled money is used to invest in commodities in various ways, according to the rules of the CPO. Buying commodity futures contracts and commodity options contracts is common, but not the only way for a CPO to gain exposure to commodity markets.
The reasons why an individual investor elects to put his or her money into a CPO varies. Many CPO:s are professionally managed and thus attractive to investors who doesn’t want to be involved in the day-to-day management of their money. Also, by pooling their resources together, investors can reach a higher degree of diversification since there is more money to invest. If you as an individual investor only have a small amount of money to invest, achieving proper diversification can be very difficult. More money also means wider opportunities when it comes to hedging and other complex risk-management methods.
The legislation regarding CPO:s can vary considerably from one jurisdiction to another, so it is important to research the specific CPO that you are interested in. This includes issues such as record keeping, disclosure of risk, distribution of periodic account statements, and distribution of annual financial reports. In the United States, a CPO must employ a Commodity Trading Advisor registered with the Commodity Futures Trading Commission (CFTC).
Closed or open CPO?
In a closed CPO, all investors must contribute the same amount of money. For open CPO:s, this is not required.
In a mutual fund, investors pool their money in a mutual fund and give a professional manager the right and duty to manage the fund. The fund will typically have a specific focus, e.g. investments in certain industries, certain types of derivatives, certain geographical areas, etc.
Since the regulations vary from one jurisdiction to another, it is important to research the legislation applicable to the specific mutual fund you’re interested in investing in. In the U.S., mutual fund are required to be managed by Registered Investment Advisor (RIA) and overseen by a board of directors or board of trustees. The mutual fund must also be registered with the U.S. Securities and Exchange Commission. It is possible for a mutual fund to avoid tax on income and profits, but to achieve this it must fulfill certain requirement as outlined in the U.S. Internal Revenue Code.
Regardless of jurisdiction, always check the costs associated with the mutual fund before you make an investment, because they can be quite high and significantly erode your investment over time. Are there fees for buying into the fund? Annual management fees? Fees for leaving the fund? Knowing how the fund will be taxed and how you will be taxed is also important.
Open-ended or close-ended?
Mutual funds are typically open-end investment vehicles open to the general public. There are exceptions though, such as the closed-end mutual fund. With open-ended mutual funds in the U.S., the fund is obliged to buy back shares (units) from investors every businesses day upon the request of the investor. It is thus very easy for an investor to exit the fund.
Open-ended mutual funds are continuously open for new investments. New investors can join the fund and existing investors can put new money into the fund at any time. This is because the open-ended mutual fund can create an unlimited amount of shares/units. When you invest in the fund, the price you pay per share is based on the net asset value of the fund.
With a close-ended investment fund, a certain number of shares/units are created when the fund is started. It is then rather complicated (but not impossible) for the fund to create new shares/units. New shares/units are typically only created if the close-ended mutual fund becomes extremely popular. Since new shares/units are rarely created, those who wish to invest in the fund would normally have to find a current owner willing to sell their shares/units to them. This can cause price rallies where the market price of 1 share/unit becomes higher than the net asset value of the close-ended mutual fund.
An index fund is a type of mutual fund that isn’t actively managed in the traditional way. Instead, it is passively managed with investments selected in order for the fund’s development to follow an index, e.g. the Dow Jones Industrial Average. Index funds are usually associated with much lower fees than other mutual funds.
Money Market fund
For information about money market funds, please visit the article “Investing in a Money Market Fund” on our site.
ETFs & ETNs
ETF stands for Exchange-traded Fund while the acronym ETN denotes an Exchange-traded Note. Both products are highly standardized and traded on exchanges. When an asset or derivative is exchange traded, it usually means higher liquidity and smaller spreads. One example of a popular ETN is the Commodity ETN, a note designed to track the price fluctuations of a certain commodity or basket of commodities.
- Since the ETN is unsecured and backed by its issuer, credit risk should be taken into account before you decide to trade in ETN:s.
- In the United States, a ETF that doesn’t invest in securities does not fall under the Investment Company Act of 1940. The public offering is however still subject to SEC review and the fund must obtain a SEC no-action letter in accordance with the Securities Exchange Act of 1934. ETF:s that invest in commodites may also be required to adhere to the rules set by the Commodity Futures Trading Commission.