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How to Profit From Falling Commodity Prices

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You’re convinced that commodity prices will continue lower, so how do you profit from that move? Inverse exchange-traded funds (ETFs), futures and options on futures provide direct exposure to price movements, but before taking a position investors should consider whether to trade a broad market index or focus on specific markets.

Graham Day, CFA, director of product development and sales at Elkhorn Investments in Wheaton, Illinois, cautions that individual commodities don’t always move in sync and shouldn’t be treated as a single market. He cites higher prices in cattle and cocoa, both of which have had strong performances over the past three years, as examples. “You have to be able to look at individual commodities because there’s always going to be pockets of opportunity,” he says.

Many investors are familiar with taking long positions in exchange-traded funds (ETFs) so doing the same with inverse ETFs can be a natural choice. According to Zacks Investment Research, 20 inverse ETFs for commodities were available as of mid-September. The funds covered both indexes and focused markets, such as agriculture, precious metals, gold miners and industrial metals. All the inverse funds showed positive returns for the past 12 months, ranging from 8.9% for the DB Gold Short ETN (DGZ) to 300% for the VelocityShares 3x Inverse Crude Oil ETN (DWTI).

Inverse ETFs offer convenience, says Carley Garner, senior futures market strategist and commodity broker with DeCarley Trading in Las Vegas, Nevada, and author of “A Trader’s First Book on Commodities.”

Most investors with access to a stock trading account can trade these funds but they may need to take an extra step or two beforehand. Fidelity Investments, for instance, offers trading of inverse ETFs but customers must agree first to the terms of Fidelity’s Designated Investments Agreement, which covers things like risk tolerance and requires customers to have the appropriate investment objective.

Inverse ETFs also have drawbacks. The small number of funds and the limited coverage of specific commodities restrict investors’ choices. ETF tracking errors and technical factors like futures contract rollovers can also affect returns relative to the underlying commodity. “Sometimes you can be dead right on the direction of the commodity but the ETF doesn’t really follow through as far as your profits and losses,” says Garner.

Getting Short

Selling futures provides multiple advantages over trading inverse ETFs, she maintains. Futures markets have longer trading hours and offer greater market coverage, and their contracts move directly with the underlying commodity.

“The purpose of going to the futures market would be to get a pure speculative play,” Garner says. “So, for example, if somebody thinks crude oil is going lower, the most efficient way to play it would be to just simply sell a crude oil futures contract. That way you’re truly getting the penny-for-penny movement of the commodity itself and there are no other interferences.”

A critical difference between trading futures options and stocks is that futures allow investors to take on much more leverage. The amount required to trade a crude oil contract worth approximately $45,000 is only $5,000, for example. That degree of leverage can produce high returns but it can also quickly drain an insufficiently funded account and lead to margin calls if prices move against the investor.

Responsible traders don’t utilize maximum leverage, Garner says. Citing the $45,000 oil contract, she maintains that funding the account with $20,000 or more would be prudent.

Trading options on futures is another alternative to inverse ETFs. Garner says many of her clients use option spreads and other strategies instead of buying options outright. These methods can help reduce volatility, but market conditions vary, she cautions.

Some options markets, such as those for the E-mini S&P, crude oil and Treasurys, are very liquid with tight bid-ask spreads. That’s not true for low-volume markets, though. Garner cites copper options as an example: “Even though copper is a very widely traded futures contract, for some reason the options have just never picked up. There’s just not a lot of volume there. The bid-ask spreads are enormous to the point where even if you bought a put option and you were dead right and copper dropped 10%, you may not even make money on it just because of the option illiquidity.”

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