The Surprising Truth About Commodities Futures and Options

“Traders need to diversify. And if the next several years are as bumpy for stocks and bonds as some analysts expect, commodity futures and options might provide the kind of returns investors need.”

Commodities and natural resources used to be the butt of jokes and misconceptions. Now they are finally getting the respect they deserve. Traditional investors and advisors are rushing into commodities, hoping to find the high growth that traditional equities no longer deliver.

But even with the commodities turnaround, there is still one sector of the real asset market that is still taboo to many mainstream investors. I’m talking about the commodity futures markets.

Investing in Commodities and Future Resources: Commodity Futures Markets

Resource stocks and stock options are fine for most investors. But they still think that trading in the futures markets is nothing more than gambling.

And that’s a real mistake. The fact is, traders need to diversify. And if the next several years are as bumpy for stocks and bonds as some analysts expect, commodity futures and options might provide the kind of returns investors need.

But please don’t get me wrong – I’m not saying that futures trading is risk-free. Risks – and even losses – are a part of every kind of trading. Stock… real estate… even the U.S. dollar are full of risk.

Yes, commodities carry risk… but they are not intrinsically risky. What makes them risky is the same thing that makes them attractive – LEVERAGE. You can trade futures on very, very low margin.

So the question becomes, exactly how risky are futures? The truth may surprise you.

Investing in Commidities and Natural Resources: Commodity Futures

For example, Gary Gorton of the University of Pennsylvania and K. Geert Rouwenhorst of Yale researched commodity futures contracts between 1959 to March 2004.

Their first major finding commodities are negatively correlated with stocks. That is, they often move one way when stocks are moving another, and vice versa. So diversifying a stock portfolio into commodities can significantly reduce your risk.

Of course, that’s something we’ve been saying all along. But there were some surprises in the professors’ findings.

Previous studies have shows that commodities are able to match equities’ returns. But the index model they constructed showed commodities were about 19% less risky than the S&P 500.

That’s right – buying futures contracts was less risky than buying stocks. Thus, on a risk-adjusted basis, they outperform stocks by a significant margin.

They also discovered something very interesting about the different markets’ volatility. It turns out that a disproportionate amount of stocks’ volatility came from months in which they lost significantly. Meanwhile, an outsized portion of commodities’ volatility came from months in which they scored big gains.

In other words, the professors found that stocks have greater risk on the downside than commodities do.

Those are some pretty strong arguments for considering commodity futures and options for your portfolio. But can you get the same results just holding resource stocks? Not quite…

According to Gorton and Rouwenhorst, over the last 40 years, the commodity futures index more than tripled the cumulative performance of average resource stocks involved in the production of those commodities. They conclude: “An investment in commodity company stocks has not been a close substitute for an investment in commodity futures.”

I agree.

That’s not to say there’s anything wrong in investing in resource stocks. But your goal should be to maintain steady long-term growth. And the fact is, equities are the best way to do that.

Kevin Kerr

The Daily Reckoning