The last few years haven’t been kind to commodity investors. Most natural resources have been under pressure as supplies continue to grow while demand evaporates. Excess capacity was brought on by many hard asset firms just as the boom was going bust, thanks to the long lead time to start producing from a mine or oil well. Meanwhile, global growth has been anemic at best since the credit crisis and global recession. That’s clipped demand for most commodities and that demand has never really returned to pre-crisis levels.
This supply and demand metric has only been more eschewed as China’s growth has recently vanished. China is a leading consumer of almost every commodity on the planet. Meanwhile, the rising dollar has continued to put downward pressure on all matters of hard assets.
Needless to say, the overall commodities boom could become a bust. And yet, there might still be money to be made in the commodities sector by going short. Here are four ways to do that.
1. Short Commodity Stocks
If your profits are determined by commodity prices, then lower commodity prices will undoubtedly crimp those profits. And lower profits ultimately lead to lower share prices. That makes shorting individual hard asset producers a prime way to play dwindling natural resource prices. Stocks like Newmont Mining (NEM) and Peabody Energy (BTU) are basically proxies for their underlying commodities.
Shorting stocks is actually a relatively easy process for liquid stocks. Basically, investors must apply for a margin account with a certain amount of assets, usually a minimum of $5,000. The next step is to borrow shares from a broker and then sell them. If the price of the stock falls, you buy back the shares later at that lower price. The difference is your profit.
There are some downsides, however, to shorting. For starters, you’ll pay interest on the margin balance, and that can be as high as 8% for some brokers. Secondly, you could be subject to margin calls if the value of the assets in your portfolio dips below a certain point. That means you’ll have to pony up more cash or sell positions to cover the balance. Finally, and perhaps the biggest risk, is that your losses aren’t capped when shorting. Unlike going long a stock, when you can only lose what you invest, a shorted stock can continue to rise essentially forever. That can be huge if you aren’t careful.
2. Short Individual Country ETFs
Some nations are hot beds of hard asset production, deriving much of their GDP growth from them. The exchange-traded fund (ETF) boom has allowed investors to directly bet on these nations. And like the previous example, going short on them is equally as easy as going short a commodity producer stock.
3. Use Inverse ETFs
If the idea of using margin and shorting stocks scares you, then using inverse ETFs could be the next best thing. In simplistic terms, an inverse ETF will use futures and swaps to create a synthetic short position in a commodity or natural resource sector. For example, the ProShares UltraShort Gold ETF (GLL) bets on gold prices, while the Direxion Daily Gold Miners Index Bear 3x ETF (DUST) bets on gold mining stocks.
If the value of a commodity drops by 1%, then the ETF will rise by 1%. Over long stretches of time, though, compounding chews away at the percentages, so inverse ETFs are best for short- to medium-term bets on commodity prices.
What’s more is that there are now leveraged versions of many inverse ETFs, promising 2x or 3x the return in a single day. This allows smaller investors the ability to juice their returns. However, the downside is that losses could be magnified.
4. Short Futures or Options
For sophisticated or higher net-worth investors, going into the trading pits and actually using futures and options contracts for underlying commodities is really the only way to go. Futures represent a contractual agreement to buy or sell a particular commodity at a predetermined price in the future. This means that if you hold the contract till it expires, you’ll be on the hook for 25,000 pounds of copper.
Options on the other hand give you the right to enter into a specified futures contract, long or short. The vast majority of options contracts expire without the investors exercising the right to buy or sell the underlying commodity. Basically, they allow you to bet on the futures price without some of the risk of having to actually pony up the cost to buy. Options prices rise and fall along with the underlying natural resource price.
The problem with using futures/options is that the sector can be very complicated to understand and has tons of risks, not to mention large starting capital requirements and the potential for huge losses.
The Bottom Line
There are plenty of easy ways to short commodities. These can be as simple as using an inverse ETF or as complex as futures strategies. All in all, there isn’t an excuse not to get tactical with your portfolio exposure.
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