Liquidity is a concept that investors often overlook. In a standard brokerage account with a stock portfolio, liquidity isn’t really a factor. Stocks can be traded and sold at a moment’s notice so investors never really see the effect that a lack of liquidity can have on an investment portfolio.
Investors might remember what happened to the real estate market in late 2008 and the subsequent market crash that followed. Mortgages are illiquid investments that can’t easily be converted to another medium like stocks can. When the real estate bubble collapsed, investors were left holding properties valued at less than they owed on the mortgage and the lack of buyers meant many ended up in foreclosure.
The key to being successful in the commodities market is knowing what kind of liquidity differences come with each investment and how to avoid making costly mistakes.
To learn more about investing in commodities, be sure to follow our education section here.
How Liquidity Impacts Commodities Versus Other Investment Vehicles
A commodity is defined as a good or product with uniform quality and that can be traded for the same type of commodity without regard to foreign currency differences or country of origin. Some of the most commonly traded commodities include oil, natural gas, wheat, soybeans, cocoa and more. Derivatives like foreign currencies and interest rate swaps are also considered commodities and trade on various futures exchanges.
Interested in knowing which commodities are traded more frequently? Check out our recently published article here to learn more.
Stocks trade much differently than commodities. Publicly traded companies issue shares of stock that investors can purchase, making them part owner of the company. Shares may be bought and sold easily between investors, making stocks highly liquid investments.
Other investment vehicles like ETFs and mutual funds have relatively high liquidity compared to commodities as well. ETFs in particular are designed to trade like stocks, making them equally liquid, whereas mutual funds trade once at the end of each trading day. While not quite as liquid as stocks or ETFs, mutual funds are still considered a liquid investment.
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Understanding Volatility in Commodities
While most investors have some level of familiarity with volatility in the markets, commodities operate with a higher average volatility, making them riskier investments than common equity stocks. Unless fraud is discovered in a company, the odds of a stock becoming worthless in a single trading day is virtually zero. Commodity investments, however, can experience large swings in value day-to-day on a regular basis.
Margin accounts and leverage are ubiquitous in the commodities space. Investors with a standard brokerage might have a margin account to leverage investments or use options in their trading practices. In the commodities space, a single contract contains large quantities of the underlying good. Gasoline futures, for example, trade in 42,000 gallon contracts, which means leverage is the best way of actually investing in commodities.
One thing that makes commodities riskier investments is how accounting is performed. In mark-to-the-market accounting, positions are closed out at the end of each trading day with profits and losses tallied against an investor’s margin account. Because many commodities use leverage, in some cases as high as 200:1, even a small fluctuation in a single trading day can result in significant losses. For example, if an investment fell 1% and had leverage of just 10:1, the total loss would amount to 10% of the overall investment.
Key Differences in Commodities
One detail when it comes to investing in commodities versus stocks is how the ask-bid spread differs. This is the amount charged by a brokerage to execute trades and is highly dependent upon the liquidity of the asset. Since stocks can easily trade hands, the spread is usually low enough that investors never really notice it, but in commodities where liquidity is a concern, the spread can be high enough to be a significant consideration. The cost of simply buying and selling a commodity contract can be expensive enough to counter the gains one earns, making the investment ultimately useless.
Not all commodities have the same level of liquidity – even within the same category. For example, crude oil trades far more frequently than coal, making the bid-ask spread on crude oil contracts smaller. Investors looking for commodities with high liquidity should pay attention to daily trading volume and open interest – the higher those figures, the more liquid the market.
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The Bottom Line
When investors add commodities to their portfolio, they need to be aware of the liquidity differences when compared to stocks. The added volatility of commodities markets combined with the various levels of liquidity means that investors should have a more sophisticated understanding of global financial markets before they begin using commodities. A properly diversified portfolio should also account for liquidity so investors won’t be caught in a downward spiral, unable to sell out of their holdings. Understanding the differences between various commodities contracts is also key for investors to ensure that their holdings aren’t tied up in illiquid investments.
Be sure to check out our news section to keep track of the latest commodities news.