How to Leverage Your Position in Commodities

The commodities markets are reserved for few brave traders, who usually are market veterans. When someone thinks of trading, pork bellies, dairy, or raw sugar is probably last on the list of tradable goods. But there is plenty of money to be made in commodities, and they offer nice portfolio leverage.

Commodities by definition are anything that can be traded. In finance, commodities are any raw good that can be bought and sold on the open market. Gold tends to be the market’s favorite type of commodities, due to its constant supply and the liquidity in the gold market.

Three golden markets

Gold can be purchased in three different ways. First is the physical possession, or the purchase of gold coins or bars for an investment. This is the most illiquid and most expensive way to buy gold. Coin stores and gold vendors will often tack on a hefty charge to cover the market fluctuations of gold.

The second way to purchase gold is through the markets, either in futures or spot commodity prices. This market has the advantage of lower spreads for gold and the ability to buy and sell as needed. Unfortunately, the futures markets are very exclusive and require high minimum investments for most people. The leverage in futures makes this a great investment solution, but should only be considered by professionals. The futures market is no place for inexperienced or part-time investors. It is easy to get caught up in the shock and awe of 100:1 leverage.

The third way, which is the best for long-term investment, occurs in the form of gold mining or refining corporations. Purchasing stock in a company brings the investor ownership, which includes some value to back up the metal that is being mined. In times of high gold prices, the mining companies fly through the roof. In times of low gold prices, gold companies are likely to lose value, but will still retain ownership of the mines. The cold hard assets of a corporation easily trump the high spreads in physical gold and the volatility of leveraged futures.

How it works

Buying stock in gold related companies does afford the ability to leverage your investment. While futures offer direct leverage, the stock markets allow you to buy companies that will disproportionately benefit from high gold prices. Take for example ABC Gold. Consider for the sake of this discussion that gold is worth $750 per ounce.

A golden example

ABC gold currently operates gold mines that cost $500 to produce one ounce of gold. ABC gold also owns mines that can produce gold, but the efforts are only cost-effective only if gold prices are above $800 per ounce. ABC gold produces 100 ounces per year at $500, generating a profit of $25,000. When gold prices move to $1000 per ounce, ABC gold produces 200 ounces of gold, 100 ounces from each mine, earning the company $45,000. As you can see from the oversimplified example, ABC Gold’s income nearly doubles while the price of gold moves up only 33%. In this sense, by investing in ABC Gold rather than actual gold, the investor stands to leverage his or her investment and make a greater return.

Another benefit to investing in corporations rather than metals is that metals do not pay dividends. Futures accounts will actually drain money from the leveraging. By investing in real companies, you will receive a dividend check for your ownership, along with having a net positive exposure to gold.

The best way to invest in commodities is indirectly. Mining corporations have the advantage in leverage, cost, and the dividends paid for ownership. While physical gold is always the best insurance against economic turmoil, your money is safe in the ownership of mining companies.

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