Let’s start by stating the obvious. Commodities exist in the physical world. That means they are very different from stocks, bonds or cryptocurrencies.
Those asset classes can move around the world with a keystroke. Commodities must be transported. That is both costly and time-consuming. They degrade and spoil, are stolen, hidden and fought over. Meanwhile, their prices can move in an exceptionally volatile manner. That means fortunes can be quickly made or lost.
They are also totally essential to our daily lives. I’m not ready for the day until I’ve had my coffee, for example! It doesn’t matter what happens to the stock or bond markets – commodities will always exist and so will our need for them.
Sign up to Money Morning
Don’t miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter
Don’t miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter
Commodities offer valuable diversification from other assets: they may rise when most markets fall. Individual commodities often also trade very differently from each other, so that offers an additional avenue for diversification within the commodity asset class.
How commodities trade
Commodities trade on both a “spot” basis (the price to buy them immediately) and as futures (the price for delivery at a given point). Of course, as a financial trader, you don’t actually take delivery of these physical items, but this reality is reflected in how these markets behave.
Futures prices have a relationship to spot prices, but they are not the same. The difference reflects both expected changes in supply and demand and also, crucially, the “cost of carry”. It costs money to store commodities, so as soon as you open a commodity position, you are paying for storage. Those costs are mostly wrapped into the price of the various instruments that you trade, rather than being charged explicitly – but they are always present. That’s why, for example, spot crude oil might trade at $85 per barrel, futures for delivery in three months at $87 and futures for delivery in a year at $90.
Experienced traders who are able to put up the large amount of capital required may sometimes trade commodities futures directly. However, traders can use also spread betting and contracts for difference (CFDs) and these require less capital, as well as being simpler to start learning the principles.
Spread betting and CFDs
You can use spread betting and CFDs to trade both the spot price and futures prices. Exactly what is available will depend on the commodity and on the provider you use – some will have more choice than others. If you trade the futures price, the bet will follow the conventions of the underlying futures market. For example, gold futures contracts are three months long, while natural gas futures contracts expire at the end of every month. (You can, of course, close your position at any time before expiry.)
Let’s take an example of spread-betting gold and see how it relates to spot prices and futures prices. At the time of writing, the spot price of gold is trading at $2,471 per oz. The December futures prices (ie, gold to be delivered in December) are trading at a spread of $2,510-$2,510.60 (ie, you can sell at $2,510 and buy at $2,510.60). That $39 difference between spot gold and December gold is the holding cost of gold for four months. If gold prices simply go sideways for two years, those costs add up and eat into your capital. That’s why most commodity trading strategies rely on trading volatility rather than buying and holding.
Let’s say that I want to bet that gold will rise. I buy the $2,510.60 price. Spread bets are based on pounds per point, with a point here being a $1 move. Say I bet £10 on my gold wager. If gold rises $50, I will make £500. If gold falls $50, I will lose £500. You will notice from the above example that currencies don’t come into this: you can bet pounds on a dollar-denominated instrument because you are betting on the number of points moved rather than the strict value of the product you are trading.
Spread-betting firms also offer daily rolling bets on spot prices. The spreads on these bets are tighter, so they are less expensive if you are a day trader (ie, you are getting in and out of the position on the same day). However, the costs will mount up if you roll over the bets from one day to the next: the provider will close the bet at the end of the trading day and open a new position for the next day, and you pay the spread a second time. My rule of thumb is if you intend to hold the position open for more than three days, it is less expensive to bet on the futures price than the spot.
Ultimately, both spread betting and CFDs work in a similar manner to trading futures directly. However, they may limit the strategies available to trade. For example, they do not allow calendar spreads (where you go long a futures contract with expiry on one date and short a contract that expires on another date).
The problem with commodity funds
An alternative way to trade commodities is to buy exchange-traded commodities (ETCs) – funds that are traded on the stock market and bought and sold through a stockbroker. ETCs typically work by taking positions in futures contracts and regularly roll the position into the next maturity before they expire.
How well these kinds of funds perform is closely related to the cost of rolling these futures over for a prolonged period. The prices of the futures contracts factor in the cost of holding the physical commodity until expiry. In addition, since most commodity trading is leveraged, the cost of borrowing the money to hold a position is also factored into the price of the futures contract. The result is prices can vary significantly from one contract to the next, just as we saw with the difference between spot gold and the December contract above.
As a broad rule, the normal condition in the commodity markets is that the price for delivery in future is higher than it is today (known as contango). That makes sense: if I buy copper, it costs me money to hold it for three months, and so I will want a higher price to commit to selling it when the contract expires in three months than selling it now.
When markets trade in contango, ETCs do not tend to perform well, because to roll over they must sell lower-priced futures contracts that are expiring and replace them with higher-priced ones expiring further ahead. They will only generate positive returns if the price rises enough to offset what they lose on each roll.
However, there are times that prices are higher in the present than in the future (known as backwardation). These are generally associated with supply shortages. This happened recently in the cocoa market: there have been several bad harvests and it takes several years to grow new trees. The shortage of available supply created higher prices overall, but also backwardation because cocoa buyers are scrambling to get hold of supplies immediately. Futures-based ETCs do best on the rare occasions when backwardations more than compensate for the cost of holding.
Some ETCs hold physical commodities rather than commodity futures. These funds are usually limited to metals, because these don’t rot and they are dense (you don’t need a lot of storage space to hold a significant volume of material).
The biggest physical metal ETCs are the ones that invest in gold. Using these funds keeps the cost of holding physical metal as low as possible. At the same time, they remove the leverage, risk and cost of trading gold via futures. Many traders and investors see them as the most convenient way to get exposure to the gold price. Of course, they are not appropriate for anyone who wants leverage to the price of gold.
A final note: trading commodities can be profitable, but they are very volatile and not straightforward. There are many different ways to participate in the commodity markets. The most important thing to remember is that all commodities behave according to their own unique characteristics and traders should study these markets carefully before starting to trade.
Eoin runs the Fuller Treacy Money investment strategy service (fullertreacymoney.substack.com).
This article was first published in MoneyWeek’s magazine. Enjoy exclusive early access to news, opinion and analysis from our team of financial experts with a MoneyWeek subscription.
