How to invest in commodities? A comprehensive guide by Digimagg

Including commodities in a portfolio offers diversification and potential protection against price fluctuations in various industries. Energy (e.g., oil, gas), agricultural (e.g., corn, soy), and metals (e.g., gold, silver) are common commodities with straightforward trading options. Unlike many financial assets influenced by market sentiment, commodities are often priced based on demand and processing requirements. This guide will explore major commodities and strategies for incorporating them into your investment portfolio.

How to invest in commodities?

Investors have various avenues to access commodities.

Physical ownership

Primarily applicable to precious metals like gold and silver, physical ownership involves purchasing bullion in standard sizes and purity. However, this method entails challenges such as storage, insurance, and liquidity issues. Other commodities pose additional hurdles due to larger quantities and shelf life constraints, making physical ownership less common. To trade physical commodities, investors need reputable dealers and possibly storage facilities.

Futures contracts

Futures contracts offer direct exposure to commodity prices. These contracts involve agreements to buy or sell a specified amount of a commodity at a predetermined price and date in the future. Investors use leveraged margin accounts to amplify their positions. Most trades are cash settled, eliminating the need for physical delivery. Trading futures contracts often requires additional paperwork for margin trading and higher account minimums, with maintenance margin requirements varying based on contract value.

Individual securities

Accessing commodity-related securities is possible through a standard brokerage account. Investors can identify relevant companies using stock screeners, focusing on basic materials or energy sector firms. However, success in this approach may require industry-specific knowledge. For instance, mining and energy extraction companies conduct feasibility studies on reserves, impacting stock value. Larger companies with diverse reserves exhibit lower volatility, while smaller firms may experience heightened price fluctuations based on individual feasibility study outcomes.

Mutual Funds, Exchange Traded Funds (ETFs), and Exchange-Traded Notes (ETNs)

Exchange-traded products such as commodity-based mutual funds, ETFs, and exchange-traded notes offer exposure to commodities. Some exchange-traded products focus on individual commodities, pooling investor funds to create a commodity pool. Investment strategies vary depending on the fund's objectives, which may involve purchasing futures, options on futures, shares in sector companies, or acquiring and storing physical goods. Certain funds employ leverage to magnify price movements, aiming to provide double or triple the commodity's price changes. It's essential to review fund disclosures before investing to ensure the offered exposure aligns with your investment goals.

Commodities fall under alternative investments, along with assets like real estate, which don't adhere to conventional stock and bond trading methods. Within precious metals, there's a subset of alternative investments that resemble collectibles more than traditional investments. Bullion coins and jewelry possess aesthetic and historical value, often trading at a premium compared to metal melt prices. While these physical investments can appreciate, their prices are less tied to market prices. Jewelry can be purchased from stores, and coins can be obtained directly from mints or dealers, but they are primarily collectibles rather than commodity investments.

What requirements are necessary to open an account for investing in commodities?

Opening a commodities investing account mirrors the process of opening a standard brokerage account. If you aim to invest in commodities via companies and funds, it's akin to a standard brokerage account since no special requirements are needed. However, for futures and options trading, ensure your broker offers these options. Additionally, you may need to provide extra disclosures to affirm your comprehension of risks and sufficient capital to avoid potential losses from a single trade.

What are the requirements for opening a brokerage account?

To establish a brokerage account, you'll need to furnish personal and financial details and address basic inquiries.

Personal details

This includes:

• Full name, address, and contact number
• Tax ID number, typically your Social Security number
• Date of birth and a government-issued ID
• Banking particulars for funding the account
• Level of investment expertise and risk tolerance (KYC questions)

For online brokerages, the process usually begins with setting up an account (email and password), followed by providing these additional details during onboarding.

Minimum deposit

While many brokerage accounts have no minimum deposit requirement, enabling futures trading in a margin account usually necessitates maintaining a few thousand dollars with the broker. The actual capital required for trading, depending on the contracts being traded, will exceed the minimum deposit amount. Both initial and maintenance margins for futures accounts may vary based on the account type (individual retirement account vs. non-IRA account).

Pros and cons of commodity investing

Commodity investing, much like any other form of investment, has its share of advantages and disadvantages.

Pros

• Inflation Hedge: Commodities often rise in value during inflationary periods, making them a valuable hedge against inflation. While specific market conditions may affect individual commodities, overall, they tend to move in line with inflation, offsetting its impact on other assets in a portfolio.
• Diversification: Commodities offer diversification benefits due to their low correlation with financial assets. Their value is primarily influenced by factors such as supply and demand rather than economic indicators or central bank policies.
• Potential for high returns: Certain commodities, such as oil, gold, and agricultural products, can experience significant price movements, presenting opportunities for substantial profits. Factors like production forecasts and global events can drive these price swings, attracting investors seeking high returns.

Cons

• Lack of income: Unlike bonds or dividend-paying stocks, commodity investments do not generate income. Instead, returns depend solely on correctly predicting price movements.
• High volatility: Commodities markets can be highly volatile, with prices susceptible to rapid shifts driven by global events. For example, geopolitical tensions or adverse weather conditions can cause significant fluctuations in commodity prices.
• External risks: Commodity investing is exposed to various external risks beyond an investor's control. These include geopolitical conflicts disrupting supply, adverse weather affecting production, regulatory changes, and political instability. While these risks contribute to market volatility, they also present opportunities for significant returns.

Considerations when opening an investment account

Commodities investing may not be available through all brokers, particularly digital investment platforms focused on ETFs and stocks. However, larger brokers and trading-focused platforms often offer futures trading. Consider the following factors when opening an investment account for commodities trading:

Customer Support

Brokerages vary in their customer service offerings, from traditional phone and email support to in-platform chat and social media channels. Choose a broker with customer service options that align with your preferences.

Fees

Fees for commodities trading are typically calculated per contract and can vary significantly. While low fees are attractive, consider the overall quality of the trading platform in relation to fees.

Available Assets

Ensure the broker offers access to major futures exchanges if you plan to invest directly in commodities futures contracts.

Security and reputation

Look for brokers with strong security protocols, including two-factor authentication, to protect your portfolio and data from breaches.

Minimum deposit

While low minimum deposits are favorable, consider the capital required for futures trading and ensure you can handle potential swings in the market without significant portfolio impact.

Research tools

Robust trading platforms with advanced research tools can aid in understanding market dynamics. Look for brokers that offer comprehensive tools for analyzing market data, charts, and news relevant to commodities trading.