For the majority of investors, a low-risk investment strategy offers a sturdy foundation for other, more aggressive trades. But what makes a smart commodities strategy? Most investors opt for one of two major approaches: ETFs or spread trading.
ETFs: A contained approach
ETFs – exchange traded funds – are a popular investment strategy because they combine a group of commodities so that stronger elements balance out more volatile ones. This includes some gold-backed ETFs that use physical gold to back up commodity values.
Other commodity ETFs include those like the United States Commodity Index Fund (USCI), which, like many of its peers, consists of over a dozen different commodities. For USCI, those holdings include gold and silver as well as live cattle, cattle feed, sugar and coffee. And what makes this type of combined fund so powerful – and so secure for investors – is that obviously the market for gold and the market for live cattle aren’t linked. When one moves, the other doesn’t, insulating the buyer.
Spread strategies
For those looking for an alternative to commodities ETFs, the other primary approach is spread trading. Spread trading involves taking opposing positions on the same commodity. Commodities futures are time-bound, so the idea is to space out those futures holdings, buying equivalent futures several months apart. Ideally, the gap between the two will favor the long spread, creating a wider gap and bigger profits.
It’s also possible to create spreads across different varieties of the same commodity, like multiple strains of wheat or sugar from different markets. Typically, if one market for a product thrives, the other may lose out that month and so, like ETFs, this kind of intermarket spread can protect the buyer.
Advantages and alternatives
Once you have a solid grasp on both ETFs and spread trading, it’s worth considering whether either one holds special advantages relative to your approach to commodities trading. And the first step to making this determination is assessing your preferred commodities.
If you prefer to trade crops, or even livestock – commodities tied to a seasonal calendar – spread trading is generally your best bet. That’s because crops and livestock are somewhat predictable, explaining why this kind of spread trading is known as calendar spread trading. If you purchase spreads where the long side is during the annual peak price period, you can just about guarantee significant profits over short-side, low-price purchases.
Those who are especially adept at spread trading might also consider a more advanced form of spread trading, known as an iron condor spread. Instead of relying on two contracts, iron condor spreads involve four contracts, two calls, and two puts with paired expiration dates. The primary advantage of the iron condor, though, is that it puts a limit on how much you can lose, while increasing the amount you can earn. Iron condor spreads are best for more experienced commodities investors who are organized and data-driven. Even a single iron condor requires close attention to market fluctuations to determine whether to close early or hold out until expiration.
As for ETFs, these prepackaged commodity combinations are ideal for investors who prefer a more hands-off approach to investment. Though you can choose your fund, you can’t select the specific combination of commodities. On the other hand, investing in ETFs means you aren’t tied to the same constant deadlines that are integral to spread trading, and so some investors are willing to trade that control for a longer-term solution.
Nothing about investing is a sure thing; if you wanted certainty, you’d simply put your money in a bank. Within the framework of commodities investing, however, ETFs and spreads are the most stable options available. And though spread trading is more likely to yield big profits, the two forms appeal to different investment styles. You just need to meet your match.
Disclosure: I do not own any of the stocks mentioned in this article.
