By Don Dawson, Online Trading Academy Commodity Futures Instructor
A popular trading vehicle for Commodity Futures has become an ETF (Exchange Trade Fund). The first Commodity ETFs came along about five years ago. You can trade these just like you would a stock. These funds are traded on security exchanges such as the New York Stock Exchange, American Stock Exchange, etc. Since the majority of investors and traders already have equity trading accounts, these funds are easily accessible to them. Adding to their comfort level, they will be using a trading platform that they already know.
In 2008, the Commodity markets saw moves into all time highs only to fall just as fast during the stock market decline amongst fear that world demand would shrink due to slowing economies. Commodity markets are driven by supply and demand. Once our stock market started to show signs of improvement, the perception was that the demand from China and India would be back online sooner rather than later. The Commodity markets started to rally shortly before the stock market did. Why is this? Commodities are raw materials that will always find their way into the economy and therefore, will react much sooner than the stock market will. Take for example building materials. Each year Copper and Lumber markets make seasonal moves up shortly after February due to homebuilders and the manufacturing of things like electrical wire, copper pipes, building materials and other products that go into building homes. If you look at a Copper and Lumber chart, you will see how they bottomed in January 2009 and were already in a nice uptrend by the time our equity markets had bottomed.
As the world population continues to expand, we should see more demand for these Commodity products, in turn, affecting the supply. People will continue to need transportation, clothing, housing, inflation protection, etc. This should create some excellent trading opportunities going forward.
Let's look at some of the different sectors in the Commodity ETF arena. Most of the major Commodities now have a market-correlated ETF. When selecting your ETF, make sure you know what is being traded in the fund. Some ETFs have just the Commodity Futures contract attached to them. Others might have companies that deal with the particular Commodity that the fund is named after. If you are looking for a pure Commodity play, then you should consider an ETF that invests in just the Futures markets.
The energy complex has several ETFs to choose from. Energy markets are made up of Crude Oil, Gasoline, Heating Oil and Natural Gas. These ETFs can become just like a story stock when the Commodity is in the news. When Oil was heading to the upper $140 range, the media could not stop talking about this market. Many people joined this rise in Oil prices by participating in Oil ETFs. Trading ETF markets takes some of the risk out of trading/investing, but markets can be very volatile and one must be prepared with a strategy to handle these changes in the markets. Good risk management is still paramount to survival, even with ETFs. I bring this up because the Oil market is a perfect example of volatility at its finest. Oil ran up to the upper $140 level and then proceeded to fall even faster down to the upper $30 level.
Some of the most widely followed energy ETFs that hold the actual Futures are:
- United States Natural Gas Fund (UNG)
- United States Oil Fund (USO)
- United States Gasoline Fund (UGA)
The iShares Dow Jones United States Sector (IYE) holds the stock of companies rather than the actual Commodity itself. These firms will deal in the production or processing of gas and oil. Investing in this fund might not be as closely correlated to the actual Commodity since there are many other variables affecting the price of each stock in the fund.
The Agricultural Grains sector includes many Commodities. Some of the larger ones are Corn, Soybeans, Wheat, Rice, and Sugar. Much of our grain supplies go to feeding livestock. Some go to producing Ethanol, while others go to feeding our ever-growing population. This is a very broad use Commodity sector. This creates many opportunities to invest.
The most popular Grain ETF is the PowerShares DB Agriculture Fund (DBA). This fund holds a basket of Agricultural contracts on Wheat, Soybeans, Corn and Sugar. This fund actually uses a weighted method to calculate the share price. For example, they use the two front months of the Soybean contract as the most heavily weighted. Then the other products get a percentage assigned of the index. Just by the construction of this ETF, you can see that the Soybean market will have more impact than the other components of the fund.
Market Vectors Global Agribusiness (MOO) is an ETF that holds stock in about 40 companies that are related to different sectors in the Commodity markets. Some of the sectors are livestock feeding/breeding, chemicals used in planting and growing crops, and different machinery manufactures for farming.
The Metals sector has been afire for the last couple of years while Gold has been in a bull market. This sector is comprised of Gold, Silver, Platinum and Copper. Some of these metals are used for industrial purposes while others are for jewelry, dental, investing and still some photography.
The most popular ETFs for the Metal markets that hold the actual Commodity are:
- SPDR Gold Trust (GLD)
- iShares Silver Trust (SLV)
If you are looking for an ETF that holds companies in the mining and production of metals, then you should look at Market Vectors Gold Miners (GDX).
Just like other areas of investments when you are trying to find a good market correlation, there can be some trade-offs in using ETFs.
- Traders do not get the tax advantage with ETFs as they would in the Commodity market where they would receive the 60/40 tax advantage. This is where you are taxed on your profits at 60% long-term capital gains and 40% short-term capital gains.
- Some ETFs do not correlate with the Commodity 100% all the time. An example would be the Natural Gas ETF UNG. Looking at the chart of both the Futures and the UNG price, you can see a big discrepancy in price during 2009. While the Futures price rallied strongly, the ETF price went down and still has not rebounded. Make sure you check the overall market correlation before investing in these funds.
- The Futures markets allow almost 24-hour trading, while the ETFs will only trade while the US stock market is open. This will handicap your opportunity to protect yourself or take advantage of price after-hours. The market will have a better chance of gapping through your protective stop, also.
A nice benefit of trading with ETF markets is that you can limit your risk by buying smaller share sizes. You can buy 5, 10, 40, 100 or any amount of share you want to fit your risk parameters. In the Futures markets, you are restricted to the size of the contract and you are not allowed to split them up. This can create more risk than most people are comfortable with.
These ETFs have leveled the playing field for the retail investor to compete with the institutions without all the excess risk. Understanding where Commodity prices are and their respected trends can give you an edge over the average equity trader/investor. You will see moves much earlier than others who do not follow Commodities. This gives you the chance to buy early and have the crowd come in and buy after you once they hear on CNBC that it is time to buy xyz stock because of a particular Commodity's impact on the company.
These ETFs can offer you a wonderful diversification in your portfolio. I hope you get the chance to use these to benefit your trading in the future.
"Defeat is not the worst of failures. Not to have tried is the true Failure." George Woodberry
Good Trading,
- Don Dawson
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