Popular Commodities (Part II): Advantages and To-Knows

Author (s): Yew Jin, Gordon Ong & Grace Chan
| Market Insights | March 2018

In continuation of Part I, what exactly are the advantages and dangers of the commodities market? This article provides an overview of the benefits and risks of the commodities markets.

 

Leveraging

The main advantage of investing in commodities is the potential for huge profits in a relatively short period of time. This is a result of the leverage used in investing in commodities. To invest, an investor first must place a ‘margin’, a form of security or deposit in case the market moves adversely against the investor. The margin also grants the investor a certain amount of ‘borrowed capital’ to leverage on, giving the investor access to more valuable stocks beyond what his or her starting capital may initially allow.

Brokerage houses normally permit greater leverage to commodities compared to equities i.e. you get more borrowed capital, which increases both the flexibility and opportunities for returns in your commodity investments. However, the use of leverage is a double-edged sword, which we will address later under the section of risks.

 

Accessibility

Another advantage of commodity trading is accessibility. The commodity markets are open 24 hours during trading days, allowing traders to trade at any time of the day. Stocks and bonds are only tradable when the individual country market is open. Moreover, commodities trading has a much lower commission relative to stocks and bonds trading.

Commodity trading also offers high liquidity as compared to illiquid assets like real estate. With real estate, your capital is essentially locked up in the property whereas you can exit a position at any time in commodities trading.

 

Risk diversification

Risk diversification is another advantage of commodity investments. As commodities are real physical assets, they react to changing economic conditions differently. This helps to diversify and hedge against the risk of declining stock markets. Particularly, commodities prices tend to go up with inflation whereas stocks and bonds perform better when the rate of inflation is stable or slowing. In fact, historical data from 1871–2010 suggests that ‘the S&P 500 and PPI for all commodities had a correlation coefficient of -0.71’, thus supporting the assertion that stock and commodity prices have a general inverse relationship (Zapata, Detre & Hanabuchi, 2012).

As commodities are not highly positively correlated to stocks and bonds, they help to diversify your portfolio by reducing risks and increasing returns over time. For instance, a well-known fact is that gold has near-zero correlation to stocks.

You can also invest in the companies investing in the commodity industry as opposed to directly investing in commodity futures or physical commodities. For example, instead of investing in gold, you may consider investing in the mining company itself.

 

Hedge against Event Risks

Commodities also act as a hedge against destabilizing events such as stock market crashes or wars. During Black Monday in 1987 and the 1990 Gulf War, stocks plunged whereas commodities held steady. Gold is an alternative of preserving wealth in the event of a catastrophe, which makes it more valuable in times of crisis.

 

The table below provides an overview of the benefits that commodities versus that of stocks and bonds.

Features Commodities Stocks/bonds
Accessibility: 24/5 market Yes No, only during individual market opening hours
High liquidity, Low Spread* Yes No
No insider trading Yes Not necessary
Risk diversification Yes No
Hedge against inflation Yes No
Huge returns through leverage Yes No
*Low Spread:  Buy price is very close to sell price

 

Risks of Commodity Trading

Before becoming excited about the possible returns from commodity trading, it is a good idea to look at the risks involved. As with any asset class, commodities do have some risks. Commodity returns may have higher volatility and have the potential of periods of underperformance. Yet, equities and commodities have rarely fallen in the same year and it is expected to be the same in the future. Over a 35-year period from 1970 through 2005, only twice did both indexes produce negative returns in the same year (Chatnani, 2010).

 

Some of the risks related to commodities trading can be monitored, such as demand and supply trends. However, other risks such as natural disasters which affect production and supply chains cannot be predicted accurately and provides additional risks for investors.

 

High Risk?

Despite legends of overnight millionaires made through commodity trading, most people, including experienced traders, still lose money in the market. However, the truth is that commodity trading is only as risky as the individual wants it to be.

 

In commodities trading, it is the investor who decides on the amount to invest, amount to leverage and frequency of investment. You can choose to invest in small amounts on any single trade, depending on your investment profile and risk appetite. However, the key lies in knowing when to hold and sell. The commodity market is notoriously known for its wild market fluctuations, but also offers exciting opportunities for investors willing to ride out market volatility in anticipation of rewards.

 

Speculation is inherently risky and managing risks is very important for a trader’s success. Although risks can be managed, it can never be eliminated completely. For instance, commodity traders may also face unpredictable losses from bad weather conditions.

 

You should also be prepared to lose part of your capital in trading, regardless of your vast experience or flawless trading strategies. The potentially large profits are available precisely because there is also a risk of substantial loss.

 

Lastly, one important note is that commodities are not income-generating assets like stocks or bonds. The only way an investor can make money is through capital gains i.e. someone is willing to buy the commodity for a higher price than what you paid for it. You may also be forced to settle your commodities future contract before exercise date as you do not have the ability to take delivery or deliver real commodities like real trading companies do. Hence, it is impossible to wait out a market downturn like you can with equities. Your investment horizon has a hard-maximum limit, and this is something to be considered before diving into commodities trading.

 

Disclaimer: The information provided in these articles is meant to help budding investors understand investing better. All recommendations, opinions, advice, or information expressed in the articles are made without guarantee on the part of NTU-IIC or the author(s). We disclaim any liability in connection with the use of this information and hope you will exercise due diligence before any investment decision is made.

 

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