Commodity Speculation: Futures vs. ETFs
Historically low commodity prices are beginning to lure investors that have little, to no, experience to markets such as gold, crude oil, natural gas, copper, and even renewable agricultural products such as grains. Due to familiarity with their stock brokerage firms and the equity markets, they tend to flock to ETFs for their commodity exposure. However, sometimes what is familiar isn’t necessarily the optimal avenue. I argue that those willing to educate themselves on the characteristics of the futures markets, and the discipline to reduce the natural leverage, will enjoy far more efficient commodity speculation in the futures markets.
Here are a few talking points that should be considered when choosing to utilize the equity market or the futures market for commodity market plays.
Futures leverage; you don’t have to use it!
Depending on whom you are speaking to, you might be told the largest advantage in trading futures is the leverage, or you might be told it is the biggest disadvantage. The truth is, regardless of whether you look at leverage as a positive or a negative, when trading commodities, you are in control of it. Simply put, although the commodity futures markets provide easy access to high levels of leverage to all market participants, traders can mitigate, or even eliminate, leverage altogether by simply funding their trading account with more funds than are required by the exchange to be held as margin.
For example, a single crude oil futures contract represents 100 barrels of “Texas Tea.” The current margin required by the New York Mercantile Exchange (NYMEX) is $5,060. Thus, as long as a trader has $5,060 on deposit in his trading account, he is free to purchase a crude oil futures contract, but doing so in a minimally funded account results in a highly leveraged position.
Assuming crude oil is trading near $45 per barrel, the total value of the asset being traded is $45,000 ($45 x 100 barrels). If you’ve done the math, you realize it is possible to experience the profits and losses on $45,000 of crude oil for as little as $5,060 in a trading account. In light of this, it is easy to see how traders can make or lose a substantial amount of money trading futures in percentage terms. Trading commodity futures without diluting the leverage by depositing more than the required margin is not unlike purchasing a home with a down payment of 10%. Homeowners during the 2006 real estate crash will tell you the downside risk can be overwhelming.
Assuming you are the type of person capable of properly managing risk and leverage, commodity futures trading is a far superior vehicle for speculation than ETFs. Nonetheless, just like not everyone can successfully live in Las Vegas without causing undue financial harm, not everyone is able to trade at a leverage level beneath that which is available.
Futures contracts are efficient and pure, while ETFs bring ambiguity.
The financial industry is full of genius marketing executives; unfortunately, the products advertised to the public aren’t always all they are cracked up to be. Most commodity ETFs are essentially funds that “invest” in futures contracts. Still, the performance of participating in such an ETF is nothing like that of having pure exposure to the commodity. Administrative and management costs and the burden of rebalancing the fund work against the efficiency of commodity ETFs. In fact, it is possible for the underlying commodity market to move substantially higher while the associated ETF essentially trades sideways, leaving little if any profit for investors.
Futures traders enjoy lower taxes and simplified reporting to the IRS.
Gains on commodity futures contracts are taxed at 40%/60% blend between short-term and long-term taxes. Thus, the obstacle of taxable gains is much more manageable for commodity futures traders than commodity ETF traders. Further, futures traders report a simple lump sum profit or loss at the end of the year, which is reported to them by their broker in the form of a 1099. There is no need to inform the IRS of each individual trade, which is a tedious and time-consuming process. Unfortunately, commodity ETF traders are required to identify and report the details of each transaction. As Kimberly “Sweet Brown” Wilkins would say, “Ain’t nobody got time for that!”
Futures trade, with liquidity, nearly 24 hours per day!
The Chicago Mercantile Exchange Group closes trade for an hour in the late afternoon for maintenance, but the remaining 23 hours per day generally see relatively liquid and active market action. Accordingly, commodity futures traders can enter or exit their positions around the clock in reaction to world events.
Buy or sell in any order.
Although there are inverse ETFs that enable stock traders to speculate on lower commodity prices, they are a highly inefficient means of doing so. Again, due to fund rebalancing, the performance of such an ETF often deviates from that of the actual underlying commodity. Further, because of the inefficiencies, even the managers and marketers of inverse ETFs generally claim they are not “buy and hold” products; instead, they are intended for trading over a day or two. Commodity futures traders, on the other hand, can sell a contract and hold it indefinitely (at least until contract expiration) to gain pure price exposure to the underlying asset.
Liquidity and efficient execution.
Many commodity ETFs are listed and traded but have questionable liquidity. As a result, in addition to the internal management fees of the fund, commodity ETF traders often face wide bid/ask spreads which adds to the hidden expense of trading the instruments.
Futures traders aren’t charged interest or borrowing fees for leverage.
Not all stock traders are granted access to leveraged ETFs, and the barriers to entry can be quite high for the average speculator. Further, equity brokerage firms typically charge interest and borrowing fees on margined positions. Futures traders, on the other hand, enjoy the luxury of free credit provided by the futures exchanges. That said, just because something is free and plentiful doesn’t mean that it is in your best interest to use it to the fullest. But at least you know that it is there if you need it at a moment’s notice.
Risk Capital Only!
Regardless of your intentions in speculation or the trading vehicle chosen, there is one common rule: Never trade money that you can’t afford to lose. If you are like me, it seems like there is no such thing as money that can be lost without some type of anguish. Nonetheless, risk capital is defined as an amount of money that, if lost, would not alter your current lifestyle. Simply put, any allocation toward direct exposure to commodities should be held to a small percentage of your portfolio.
There is a lot of money to be made or lost in all markets, but for those with the willingness and the risk capital to speculate, the futures and options markets offer some glaring advantages over commodity ETFs.
*There is a substantial risk of loss in trading commodity futures, options, and ETFs. Seasonal tendencies are already priced into market values.