How Commodities Became Mainstream Investment Assets
From Physical Markets to Futures and Derivatives
How have commodities entered the class of mainstream investment assets? A few decades ago the raw material market was a highly specialized alternative asset class. There were only two ways to invest or trade in commodities, the physical markets or the futures and futures options markets. Commodities were only available to those who dared to venture into these two areas.
Commodities Begin as Physical and Futures Markets
The physical market requires a tremendous amount of capital and the ability to make or take delivery of the raw materials. Therefore, only a few expert companies and some very well-heeled individuals could afford to wade into these markets. Trading physical commodities requires not only an in-depth knowledge of the characteristics of the markets themselves but also an understanding and expertise when it comes to the logistics for transporting a raw material from one area of the world to another, from the production site to consumption region.
Physical commodity trading is a complicated business only suited for experts in the industry.
The futures and futures options markets are the locations where commodities trade on exchanges. These products are derivatives of the actual commodity markets and mimic the price action that results from the fundamental supply and demand equation for specific commodities.
Futures and futures options often have a delivery mechanism which results in a replication of price action in the underlying physical commodity markets. That delivery mechanism often guarantees a smooth convergence of derivative and physical prices at the time of delivery against the futures contracts. These market instruments contain lots of leverage. Leverage translates to more risk. Often a buyer or seller of futures contracts can control a large amount of a commodity with only a small amount of capital, or a good faith deposit that amounts to only five to 15 percent of the total contract value of the commodity.
The leverage inherent in futures products demands that market participants assume a massive amount of risk. While the buyer or seller of futures only needs to put down a deposit for a long or short positions, they are always at risk for the entire value of the contract. Therefore, margin plays a significant role in these vehicles. Margin calculations occur on a daily basis, and at times of increased volatility, margin calls can happen at any stage during the trading day.
The Advent of ETF/ETN Products
As the 21st century began and as markets moved into the new millennium, new products came to market that made commodity investing as easy as buying and selling stocks and bonds. The introduction of Exchange Traded Funds (ETFs) and Exchange Traded Notes (ETNs) brought commodity trading to a wider addressable market than in the past.
The first commodity ETF was the SPDR Gold Shares (GLD). This product tracks the price of gold bullion and attracted a tremendous amount of interest and participation in the gold market. Other ETF products based on commodity prices followed such as the United States Oil ETF (USO) that tracks the price of West Texas Intermediate crude oil, the United States Natural Gas EFT (UNG), which seeks to replicate price action in the natural gas market as well as many others.
Today, there are ETF and ETN products that track commodities in precious and other metals, energies, soft commodities, grains and agricultural products, animal proteins as well as other more esoteric commodities like lumber, fertilizers, rare earth metals and others. Additionally, there are ETF and ETN products that seek to replicate price action in a myriad of other asset classes including stocks, bonds, and currencies.
The first vehicles were meant to replicate the performance of a commodity or other asset from the long side, or the buy-side of the market. However, as these financial products gained in popularity, new issues included ETF and ETNs that appreciate during periods of inverse market price action in the underlying raw materials. In other words, these vehicles allow investors or traders to bet on lower prices without having to go short the market.
Leveraged Products and Even More Market Participants
If that was not enough to satisfy the markets appetite for risk, over recent years there have many new ETF and ETN instruments that have appeared on the scene that contain leverage themselves. Double or triple long and short products allow the most aggressive investors and traders to position in the prices of commodities and other assets via specialized ETF and ETN products.
As an example, in the highly volatile natural gas market, two products have gained in popularity over recent years. The Velocity Shares 3x Long Natural Gas ETN (UGAZ) and the Velocity Shares 3x Short Natural Gas ETN (DGAZ) have become hugely popular market products. UGAZ trades an average of more than 2 million shares each day while DGAZ trades over 9 million. These figures were as of the beginning of October 2016, and they change with the volatility and trend of the natural gas market over time, but you can see that with around 11 million shares of these two leveraged products trading each day, they have become very popular.
The GLD, perhaps the most successful commodity ETF product trades an average of just under 11 million shares each trading session on the New York Stock Exchange.
Commodities Become a Mainstream Investment Class
Commodity ETF and ETN products have brought raw material investment, trading and speculation to a wider addressable market over recent years. The advent of these vehicles has moved commodity trading from an alternative to a mainstream investment class.
Commodity volatility tends to be higher than in almost all other asset classes. Volatility in a market creates more opportunities for profits and losses alike. Therefore, the thrill of prices that move around a lot on a daily basis makes the raw material markets highly attractive for many participants, especially as they have become available in traditional investment accounts.
The Risk Pyramid With Commodities
While commodity trading has become a lot easier over recent years, those market participants who venture into these markets need to understand the opportunities as well as the risks in the world of raw materials. Think of commodity trading as a pyramid:
- At the very top are the physical markets. In these markets, producers supply consumers of the world with their requirements of staple raw materials.
- The futures and futures options markets are just below; they are derivatives of the futures market and the delivery mechanism in many of these markets allow for prices to converge and correlate efficiently.
- The next level down on the pyramid, are the unleveraged ETF and ETN products that often use futures and futures options (as well as forwards, swaps, and other market instruments) as hedges so that they can replicate price action.
- Below the unleveraged ETF and ETN products are the leveraged instruments that tend to rely on option contracts to turbocharge results. All of the price movement in these tools that are available in our standard equity brokerage accounts today in the world of commodities are a reflection of the price action that occurs in the physical markets. However, always remember that ETF/ETN products are derivatives of derivatives.
When trading ETF or ETN products, market participants need to have a full understanding of the risk and potential rewards of the specific vehicles. They also must understand the basics of commodity trading. If they do not, the risk of losses increases dramatically. While commodities have become mainstream investment vehicles, commodity-knowledge remains highly specialized. Venturing into the raw material business requires lots of homework and study to gain the tools that will increase your chances of success.