Investing in commodities is great for portfolio diversification, but buying futures contracts can be a gamble. Here's why commodity investing can be risky.
Updated Oct 14, 2022
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Commodities & Gold
Farmland
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When the stock market is down, investors with a risk appetite have many things to turn to. They may turn to Bitcoin and cryptocurrency, invest in startups, or develop a taste for the best commodities to try and recoup some of their losses.
While commodities aren't the most volatile asset out there, they do involve significant risk. Here's what's risky about commodity investing and why you should know.
One of the most common ways to invest in commodities is through futures contracts. If you're disillusioned by the stock market, futures contracts are similar to options but trade in commodities like oil, metal, and grains instead of stocks. So why is it risky to invest in commodities?
The main reason commodity futures contracts are riskier is that entering into one is essentially placing a bet on the price of a commodity going in a certain direction by a set date.
Another reason why commodities markets are risky is that they involve high-leverage positions, meaning there's a capital requirement just to enter into a futures contract.
While these requirements are the main reasons that make commodities riskier, the commodity market behaves differently than other assets in times of inflation and often moves opposite the stock market. So while commodities are riskier than other asset classes in the long term, they serve as an effective market hedge.
For a commodities trader to take control of a futures contract, they must put down a minimum percentage of its value as leverage. Leveraged trading is the practice of borrowing against cash or another asset to increase exposure to an investment without investing more capital.
The amount borrowed can be 5 to 20 times the margin amount, which means higher leverage will cause smaller price movements to have a greater impact on the value of your commodities investment.
Commodity prices are determined mainly by supply and demand. Let's take oil, for example, since the average U.S. gas price peaked recently. Rising crude oil prices are the geopolitical repercussions of the Russian invasion of Ukraine and supply chain interferences. But who is profiting from commodity prices going through the roof?
The answer is commodities traders who placed bets on oil prices going up are now cashing out on their investments. Even less extreme factors like the transit fee hikes on vessels passing through the Suez Canal illustrate how sensitive commodity prices are to volatility caused by extraneous market forces.
Another reason commodity futures are risky is that they don't just expire at a certain date if you don't sell or exercise them. Instead, futures contracts carry a settlement obligation. Futures contracts deal with very real underlying commodities that must eventually be passed onto the supply chain.
So, if you can't handle 1,000 barrels of crude oil getting delivered to your house, then be extra careful before entering a risky position because you'll eventually have to sell it. Conditions like higher trading volume or market interest will determine if it'll be easy to exit from a commodities investment.
All in all, investing in the commodity market can be worthwhile if done right. The best commodities help to diversify a portfolio by spreading risk across different asset classes.
Retail investors who are mainly holding traditional assets could benefit from exposure to commodity futures markets to hedge against inflation and profit against the stock market and traditional asset classes.
Most commodities are positively correlated with some stocks and negatively with others, but commodities investments generally move independently of the S&P 500. A commodity futures contract serves better as a short-term investment because trading ones that are closer to expiration is usually more profitable. Investors looking for long-term exposure to commodities would prefer stock in a company that produces a commodity like oil or beef since it's less risky.
For instance, there are several ways to invest in gold and other precious metals. You can invest in gold production by buying stock in a mining company or try gaining direct exposure to the underlying asset. One way to do this is to buy a share of a gold exchange-traded fund (ETF), but gold ETFs can suffer when they're used as a tool for speculation.
The easiest way for retail investors to gain direct exposure to gold is through a precious metal investing platform like Vaulted. Investors who buy gold through Vaulted pay a small annual maintenance fee and are given a serial number that correlates with a 1-kilo pure gold bar. Vaulted is a great way to buy and sell gold for low fees, and they even offer a service that hand delivers your gold to you upon request.
Gold
A third option for gaining exposure to commodities is to invest in an uncorrelated asset that's essential for producing a commodity. One great example is investing in industrial real estate like farmland. Farmland is a versatile asset that grows in value and generates profit through the utilization of that land. While farmland investing is historically inaccessible, accredited investors can now use platforms like FarmTogether to invest directly in agricultural real estate.
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Similar platforms like EnergyFunders are designed to allow investors to access investment opportunities in energy commodities like oil and gas.
EnergyFunders is a crowdfunding platform that allows accredited investors to invest in oil and gas drilling projects. EnergyFunders' experts help manage your investment portfolio and they only partake in the profits once you make your initial investment back, which is usually about 3-5 years. This platform is great for accredited investors who want to invest in an uncorrelated asset to gain exposure to oil and gas commodities.
Oil