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Trading in Commodity ETFs

Trading in Commodity ETFs
March 02
18:53 2012

The exchange-traded fund, or ETF, can be tremendously valuable to the short-term trader. They offer many of the advantages of mutual funds—primarily the ability to invest in an entire sector, sub-sector, market, or foreign country, as a few examples, along with low expenses (virtually all ETFs are passively managed, like an index mutual fund) and reduced tax liability resulting from fewer capital gains.

Yet unlike a mutual fund, the ETF trades throughout the session, and its price floats accordingly. Mutual funds are priced only once a day at the end of the session, when the net asset value is determined based on the closing prices of all securities held in the fund. Minimum investments are typically quite large as well. This makes them unsuitable for short-term trading, so the ETF is an ideal substitute for the mutual fund.

Equity ETFs offer a tremendous range of options that can be employed in a variety of trading strategies. However, there are other flavors of ETF that are slightly more exotic. Here we’ll consider the commodity ETF.

Commodities have attracted strong interest from investors in light of the price spikes seen in recent years. While it is certainly possible to buy directly into the commodities market, traders who are accustomed to equity trading may be less comfortable venturing into it. Commodity ETFs offer a great alternative for adding commodities to your portfolio or speculating on price movements.

Commodity investments can be a great hedge, since they often move inversely with the equity markets. Gold is one of the best known, tending to rise when markets fall as well as when the U.S. dollar falls or inflation rises. Because the oil trade is denominated in dollars, oil tends to rise when the dollar falls. In an inflationary environment, commodities generally rise because their prices are rising along with those of everything else.

First, understand that there are two primary means of gaining exposure to commodities. The first, and obvious, one is with an ETF that tracks an underlying commodity. The indirect alternative is an ETF composed of companies with specific commodity sector exposure. For example, you might choose a gold ETF versus an ETF of gold mining companies, or an oil ETF versus an ETF of oil and oilfield service companies.

Either can be suitable, depending on your specific strategy, but be certain to choose appropriately. You should also know that a commodity sector ETF can move very differently from the commodity ETF, since companies are affected by many more factors than just the price of the commodity they produce. As an example, the United States Oil ETF (USO) fell 24% in 2007-09 while the Energy Select Sector SPDR ETF (XLE), which is a sector ETF, dropped only 3%.

There are also ETFs that track actual commodities, but in the form of baskets. For example, the PowerShares DB Agriculture Fund (DBA) tracks a variety of agricultural commodities in a single fund, while the PowerShares DB Energy Fund (DBE) tracks five different energy commodities: Brent crude, light crude, heating oil, natural gas, and gasoline. An ETF like DBE hedges movements in individual commodities (at the moment natural gas is at historical lows while oil is high and rising), though this aspect is less useful if you are looking for very short-term trades.

In closing, if you can find it on the options board, you can probably find an ETF for it. This is true for well-known commodities like gold (SPDR Gold Trust, GLD), copper (iPath Dow Jones-UBS Copper Subindex, JJC), and sugar (iPath Dow Jones-UBS Sugar Subindex, SGG) as well as more obscure ones like lead (iPath Dow Jones-UBS Lead Subindex, LD) and livestock (iPath Dow Jones-UBS Livestock Subindex, COW). While you may not recreate Hillary Clinton’s famous $100,000 profit in cattle futures back in 1978-79, you can certainly apply commodity ETFs in a savvy fashion to hedge or speculate.

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