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Commodities, And Why Your Portfolio Needs Them!

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 resource stock, hoping to find the high growth that traditional blue chip equities and high tech no longer deliver. But even with the commodities turnaround, there is still one sector of the real asset market that is taboo to many mainstream investors. I'm talking about the 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.

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 I and many others have 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.

Putting this new knowledge to work

So now you realize that commodities are a vital portion of your portfolio but how do we dip our toe in the water the first time? Right now this time of year is when refineries are switching over to begin making heating oil and stop making as much unleaded gasoline. Also crude oil is trading up on its highs so no matter what the crude oil is a bit top heavy right now, and I 'm a die hard ong term bull.

So how do we play it?

Well there are many ways but one way right now is to buy heating oil call spreads, also known as bull call spreads, in a later month like February of 2005. Another way is to buy unleaded put options for say December 2005. There are a myriad of ways to trade this seasonal challenge to pricing. I suggest picking one of the products or the crude itself for that matter and then deciding which vehicle to use, futures, options, spreads etc. Pick options and futures with enough time value to develop at least 4-6 months.

By using futures instead of equities you will be far closer to the underlying actual commodity than you could ever get using resource stocks. As commodities legend Jim Rogers pointed out on TV the other day, "... gold can never go to zero, oil can never go to zero, but Enron can and did go to zero." Bottom Line: the resource markets and commodities futures are a vital part to any portfolio, and part of any overall good profit making strategy. Good Luck!

Source: - by Kevin Kerr, MarketWatch (August 2005)

 

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Trading in futures and options involves a high degree of risk and may not be suitable for everyone.