High Stakes: The Risks of Commodity Investing
Investing in commodities is great for portfolio diversification, but buying futures contracts can be a gamble. Here's why commodity investing can be risky.
Published Mar 13, 2022•Updated Mar 17, 2022
When the stock market is down, investors with a risk appetite have many things to turn to. They may turn to cryptocurrency or startup investing, or they may develop a taste for commodities trading 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 you need to know about why it's risky to invest in commodities.
Why are commodities high risk?
Why are commodities high risk?
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 instead of stocks, they trade in commodities like oil, metal, and grains. So why is it risky to invest in commodities? The main reason 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 are risky is that they're high leverage positions, meaning there's a capital requirement just to enter into a futures contract.
All in all, investing in commodities can be worthwhile if it's done right.
While these requirements are the main reasons that make commodities riskier, commodities investments also behave differently than other assets in times of inflation and often move opposite to the stock market. So while commodities are riskier than other assets in the long term, they also act as a market hedge.
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For a commodities trader to take control of a futures contract, they must put down a minimum percentage of its value to be used as leverage. Leveraged trading is the practice of an investor borrowing against cash or another asset as a way to increase their 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.
The price of a commodity is determined mainly by supply and demand. Let's take oil for example since the average U.S. gas price peaked recently. Rising prices are the geopolitical reverberations of the Russian invasion of Ukraine, but who is profiting from prices going through the roof? The answer is commodities traders who placed bets on oil prices going up are now cashing out on their investment. Even less extreme factors like the transit fee hikes on vessels passing through the Suez Canal illustrate how sensitive commodities are to volatility caused by extraneous market forces.
Another reason why 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 an obligation to be settled. 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 into such a risky position because you'll eventually have to sell it. Conditions like higher trading volume or market interest will determine if it will be easy to exit from a commodities investment.
Is it worth investing in commodities?
Is it worth investing in commodities?
All in all, investing in commodities can be worthwhile if it's done right. At the end of the day, the best commodities investments help to diversify a portfolio by spreading risk across different asset classes.
Retail investors who are holding mostly traditional assets could benefit from exposure to commodities to hedge against inflation and profit against the stock market.
Most commodities are positively correlated with some stocks and negatively with others, but commodities investments generally move independently of the S&P 500. Commodities futures serve better as a short-term investment because trading contracts 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.
For instance, there are several ways to invest in precious metals like gold. One can invest in the production of gold by buying stock in a mining company, or one can 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.
A third option for gaining exposure to commodities is to invest in an uncorrelated asset that's essential for producing a commodity. One great is example is investing in industrial real estate like farmland. Farmland is a versatile asset that retains 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.
Similar platforms like EnergyFunders are designed to allow investors to gain access to investment opportunities in energy commodities like oil and gas.
EnergyFunders is a crowdfunding platform that gives accredited investors the opportunity 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.
Risk is the companion of fortune
There are a lot of similarities between options and futures. Both are high-leverage positions that bet on a price movement in a certain direction, but investing in them means taking on inherently different risks. Other than the underlying asset, what is the main difference between futures and options?
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