Commodity investing has a bad reputation. It is looked on as risky and not for amateurs. And in the highly leveraged futures markets, that's certainly true. You can quickly lose all your investment if a trade goes against you. In this article, however, I will detail a simple strategy anyone can use. It's unleveraged, relatively safe and carries a better than 50% probability of success.
Moreover, this strategy does not require detailed fundamental or technical analysis. Nor does it require extensive research. Instead, it relies on the mathematical principle of mean reversion.
Using mean reversion as a trading tool is not a new thing -- it's been around a long time. What is new though, is that now unsophisticated investors, using exchange traded notes (ETNs), can now easily make fast, simple, and relatively risk free trades in commodity markets.
How Mean Reversion Works
We live in an unpredictable world. Unforeseen events such as natural disasters, bumper (or failed) crops, civil unrest, currency fluctuations, and government policies can quickly drive commodity prices up or down. Mean reversion is simply the prediction that, over time, prices will move back to their historical average as the event's effects fade.
Over the last year sugar and coffee have been among the world's worst-performing commodities. This, of course, has nothing to do with people abandoning these indulgences (that will never happen). Indeed, consumption of both commodities is surging. Rather, a convoluted mix of bumper crops, government subsidies, and other factors has combined to, at this point in time, drive prices down.
Commodities, unlike equities, never go to zero. Low prices are their own cure -- they discourage production and encourage consumption. This in turn drives prices (and hopefully your profits) up.
Yes, the timing may be difficult, you need patience and there is no guarantee. Odds, however, are in your favor over time. Therein lies the profit opportunity.
Using ETNs With Mean Reversion
First, find one or two of the worst-performing commodities over the last year. This information is readily available on several websites (I use finviz.com.)
Next, look for a bullish ETN in that commodity. Some of the more popular ETNs are Barclays' ipath ETNS. If the commodity in question has a tracking ETN for the commodity, consider buying it on the next dip. Sell whenever you have a profit of 15-20% or six months passes, whichever occurs first.
As mentioned earlier, sugar and coffee are currently the "biggest losers" -- both are down about 28% over the last year. The sweetest sugar ETN is iPath DJ-UBS Sugar TR Sub-Idx ETN (SGG) and the most liquid coffee ETN is the iPath DJ-UBS Coffee TR Sub-Idx ETN (JO).
ETNs provide investors with a simple, tax efficient way to trade otherwise difficult-to-trade investments such as commodities. Two major risks are disinflation and financial crises.
Disinflation works against you with this strategy. If all commodities are heading down (as often happens in a market crash) it will be a headwind for even the most depressed commodity to rise. We saw this in 2009 in the wake of the market crash when virtually all commodities fell.
Financial crises are another risk due to the nature of ETNs. Unlike ETFs, which actually hold the underlying commodity, ETNs are essentially unsecured notes issued by the sponsoring financial institution. If that institution's viability is in question so are its ETNs. In 2008, when Lehman Brothers went bankrupt, the holders of its ETNs lost most of their money. So don't use this strategy if another financial crisis threatens.
Keep It Simple
It's also important to realize that the strategy should be used for short-term trading only -- at most 5-6 months. ETNs are not buy-and-hold instruments. I believe it's best to hold the majority of your long-term investments in cash, short-term bonds and equities.
Nothing is guaranteed (It may take people awhile consume all that sugar and coffee) but here's the thing: thanks to mean reversion the odds are in your favor that sugar and coffee prices will trend up from today's lows.
So, if you are so inclined, this may be a viable strategy to profit from commodities. But remember, it's for trading only -- not long-term investing -- and it works best in flat to rising markets.
Disclaimer: This article is purely informational. It is not a recommendation to purchase any of the ETNs mentioned. Investors need to consider their personal situation carefully to see if the above strategy is compatible with their investing goals.
Disclosure: I am long JO.