Until a few weeks ago, investing in commodities was easy money. But the fact is that this market can experience brutal corrections.
This happened with lightning speed recently. The most notable example was silver, which fell 27% during the week of May 2. There was also carnage in other commodities like gold and crude oil.
Yet there were some top-notch investors who made a fortune. How? Well, they were short, which allowed them to make money as prices fell.
How can this be done? Let’s take a look at three approaches:
Short Commodity Stocks: Short-selling can be somewhat counterintuitive, but it’s pretty straightforward. Suppose you think the iShares Silver Trust (NYSE:SLV) shares will fall. To short it, you will first borrow the shares from a brokerage firm and then sell them. If the price falls, you can buy back the shares at a lower price, snagging a profit.
However, you will need to set up a margin account and have a decent amount of assets, such as $5,000 or so. You will also pay interest on the margin balance.
There are several types of securities to short. Like SLV, you can focus on exchange-traded funds, which can be backed by the actual commodity.
But you can also purchase ETFs that invest in futures contracts. This allows an investor to buy a commodity in the future, say in the next three to six months. To do this, you only need to pay a fraction of the overall cost, which can lead to much volatility. In fact, it is not uncommon for the price of the commodity to diverge from the relevant ETF.
If this sounds too scary, you can short an ETF that is tied to a group of mining companies. The volatility should be lower.
Another interesting approach is short a “country.” Certain economies, like Russia and Brazil, rely heavily on commodity exports, so you can short the country-specific ETFs.
Inverse ETFs: The mechanism of an inverse ETF means that if the commodity declines 1%, the value of the ETF will increase by 1%. It’s a highly efficient way to short a market. Some examples include the PowerShares DB Gold Short ETN (NYSE:DGZ) and United States Short Oil (NYSE:DNO).
There are even double-inverse funds. In other words, a 1% decrease in the index will boost the ETF by 2%. Some examples are the PowerShares DB Gold Double Short ETN (NYSE:DZZ) and the ProShares Ultra Silver (NYSE:AGQ).
But you need to be wary. These super-charged ETFs can result in heavy losses if you are on the wrong side of the trade.
Short Futures or Options: These are really for sophisticated investors. In the case of futures, you can lose more than your initial investment. Something else: if you do not offset your contract, you will get actual delivery of the commodity. So what can you do with 5,000 ounces of silver?
Interestingly, CME Group recently increased the margin requirements on silver and crude oil futures. The goal was to reduce the price swings. But yes, it also lowers the profit potential for investors.
If you decide to use futures and options, it’s a good idea to start slow and focus on one commodity. You can also check out my latest book, which shows how to use these techniques to short commodities.
Tom Taulli’s latest book is “All About Short Selling” and he has an upcoming book called “All About Commodities.” You can find him at Twitter account @ttaulli. He does not own a position in any of the stocks named here.