Smart money | The case for commodities

Mention commodity investing and chances are one would think of it as risky and complicated. However, unlike stock investing wherein a lot goes into researching on companies, sectors and financials, commodity investing is mostly based on demand and supply concerns. Retail investors with a well-diversified portfolio and stomach for risk can consider commodity investing as a hedging tool. From a portfolio point of view, historically, commodity pricing has been less volatile compared to equity and bonds, providing an efficient portfolio diversification option.

In simple terms, a commodity is an essential good used in trade and may be exchanged for other items. Items like cereals, gold, oil and natural gas are classic examples of commodities (see The Commodities Universe). Commodities can be a significant way for investors to diversify their portfolios outside standard investments. One can have physical trading in these goods, but mostly it happens through futures contracts, where you agree to buy or sell a commodity for a certain price at a specified date.

The prime reason to consider commodities is to diversify your portfolio and provide an inflation hedge. Do remember that commodities are also volatile, and trading in them could be complex as they are not easy to predict and often depend on government regulations and laws. Most often, commodities traders bet on how a commodity’s price will move. If they think the price of a commodity will go up, they buy futures, or go long. If they think the price will drop, they sell the futures, or go short. Trading in commodities is common on the futures markets in which the agreements specify the terms of delivery of an asset for a specified date in the future.

Trading in commodities

You can directly invest in commodities by buying them in physical form. This, however, could work for small quantities and specifically in commodities like gold. But it gets a lot harder when you try to figure out the delivery and storage of crude oil, or agricultural commodities. For that reason, investing in most physical commodities typically takes too much effort for individual investors. The popularity of commodities future is mostly because of their convenience and ease of trading.

Trading in commodities often takes place on spot markets or in derivatives markets. These derivatives contracts utilise the spot market as their underlying asset and provide ownership of it to the owner at a future time for a fixed price. The commodity or item is transferred physically when the deal expires. You can trade commodity derivatives, such as futures contracts, as long as you have a brokerage account that allows for it. Corporate entities that operate in commodities use this route efficiently to control prices as well to ensure their supplies are in place.

When you trade futures, you will be needed to maintain a margin in your brokerage account. Remember, when you trade on margin, you are trading on borrowed money, which can amplify your losses. Given the volatility of commodity prices, it’s essential to have enough resources on hand to cover any margin call, which is when your broker requires you to deposit more money.

Some investors also consider investing in commodity stocks by investing in stocks of companies that produce commodities such as metal stocks or energy stocks. This is an indirect way to invest in commodities as price variation in commodity stocks may not have anything to do with the underlying commodity. You could explore investing in commodity ETFs (exchange-traded funds) and mutual funds that may follow a commodity theme such as gold ETFs and gold funds.

Should you trade?

Commodity trading is a high-risk, high-reward trading opportunity and could be used as a tactic when investing, especially by investors who can take high risks and have well-diversified portfolios. For such investors, commodities could be an effective means to hedge their portfolios against a bear market or inflation. If you can track historical price trends and data that reflect commodity price movements, you could stand to gain from commodity investing. As most of the commodity trading amounts to speculation, not investing, be sure before investing and trading about the losses that you may face when investing in them.

Advantages of putting money into commodities

Shield against rupee depreciation: The Indian rupee has an inverse relation with gold and whenever there is depreciation in the rupee, the price of gold goes up, and vice versa. Whenever the Indian stock markets show weakness, it is better to hedge by investing in commodities over equities in such times.

Liquidity: When equity markets are volatile, one can invest in commodity futures, as it offers higher liquidity compared to other financial assets like real estate. Moreover, it is easy to buy and sell commodities as one has the choice to liquidate this position when it is required.

Event risk hedge: Risks such as natural disasters, wars and economic crises have a negative effect on the prices of financial assets such as bonds and stocks. But these event risks, on the other hand, increase the prices of certain commodities, especially oil and gas and even agricultural produce. This is one reason to explore commodities, especially when anticipating an event.

High returns: Commodity prices experience extreme swings and can be used as a tactical move to benefit from the swing in prices.