Commodity Futures

• A commodity futures contract is an agreement to buy or sell an amount of a particular commodity at a specified price and date. Generally, commodity futures are leveraged investments, with actual contract being worth 10 or 20 times the margin used by the investor. Commodities can also experience wide price fluctuations in relatively short periods of time. Due to the leverage and volatility, the value of a commodity futures investment can change quickly and drastically. New futures investors should spend considerable time researching the dynamics of leveraged investments, and the potential price swings for the commodity in question.
  
  

Trading Commodity Futures

• To trade commodity futures, one must open a futures trading account with a specialized broker. Once the account is funded, the investor can research potential investments on exchanges like the Chicago Mercantile Exchange. Very frequently, traders will choose to buy a contract in the nearest contract month. To avoid taking delivery of the commodity when the contract expires, be sure your broker will roll the contract over into the next contract month upon expiration.
  
  

Commodity ETFs

• An exchange-traded fund is an investment fund that trades on a stock exchange, pooling investor money. Commodity ETFs generally invest in commodity futures contracts, although sometimes they purchase the physical commodity. Investors can choose an ETF that focuses on a particular commodity, or one that invests in a diverse basket of commodities. An ETF is easy to buy and sell out of a normal brokerage account, and carries less risk of volatility than a futures contract. However, due to the effects of contango, commodity ETFs often underperform the underlying commodities in terms of price performance.
  
  

Contango

• Contango results from the variation in price between forward and back months of futures contracts. In normal circumstances, back month contracts are priced slightly higher than forward months, to reflect carry costs related to the commodity. This dynamic is called contango. Contango becomes more pronounced when inventories are high, increasing carry cost. For ETFs that focus on near-term futures contract, contango has the effect of degrading the value of funds invested, as the fund manager is required to roll investment over toward more expensive back month contracts. Investors can reduce the risk of contango by investing in diversified commodity ETFs, or in ETFs that hold longer-dated contracts.