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“Commodities Vs. ETF's…..Is The Risk Worth The Reward To You?”

The investing world seems to be enamored with ETF's, especially those that track certain commodity products. Without going into great detail about tax ramifications and numerous other aspects to consider when investing in one product or the other I will just look at the differences in outcomes with similar dollar amount investments. For the sake of this article I will look at gold and the different outcomes based upon alternative investment strategies; gold futures, gold options, and gold ETF's. The August gold futures contract (currently most actively traded month expiring 8/29/12) is trading just above $1600 an ounce. I will use that price for the gold futures and SPDR gold shares (NYSEARCA:GLD) currently trading at $155 (approximately 1/10th the size of the futures contract) at the time of this post (6/11/12) so I will use that for the price of the ETF.

The margin requirement for one contract of gold (cost to hold a futures contract overnight in your account) is $10,125 with a maintenance requirement of $7,500 (the amount where you need to put more money up in order to maintain the position). For the sake of round numbers I will use $10,000 as the investment amount for both products. This would buy 1 futures contract of gold and $10,000 in the ETF you could buy about 65 contracts of GLD ($155 x 65 = $10,075).

Obviously the downside results are the exact opposite of the upside results. Lets hypothetically say that gold went to $1700 in the futures market…the 1 contract of gold you held in the futures would have brought you a profit of $10,000 (every $1 in gold futures is worth $100) $1700-$1600= $100 x $100 = $10,000. Since the ETF should basically mimic the move in the futures price of gold I will say that GLD went from $155 to $165 (if gold moves $100 and ETF is 1/10th then ETF moves $10) leaving you a profit of $650 ($165-$155 = $10 x 65 contracts = $650). So the ratio here is 15-1 on money made if you held the actual commodity over the ETF and got a $100 move in gold futures. In order to protect myself from downside risk in the futures contract I could buy the $1580 put for @ $4,850 which would bring my net dollar investment up to around $15,000. In this case you could conceivably buy $5,000 more of GLD (so equal investment amounts) bringing your net contracts to about 95. So if gold futures were at $1700 at expiration you would only make $5,150 on the futures because your put would have expired worthless and your GLD would have brought you a profit of $950 (95 contracts x $10 made). The reward ratio is now at 5-1 bought you protected yourself this time in the futures trade. This is just one of many ways to protect your position through the use of options. In any investment I believe you can't make greater rewards without taking greater risk unless you know something I don't.

Now I will discuss another way to put $10,000 to work being long gold via the use of options. If an investor looked at buying the September gold options (expires 8/28/12 so 1 day before the futures contract) $1600-$1700 call spread. The cost for this strategy would be approximately $3,500 per spread. The breakeven at expiration is $1635 (lower strike price + premium paid) in the futures market. Conceivably an investor with $10,500 could buy 3 of them ($3,500 x 3 = $10,500). If gold were to settle above $1700 at expiration the position would make $19,500 ($6,500 x 3 = $19,500). To show you that is the best possible outcome would be an injustice in the sense that you must see the downside of using the options strategy. If gold futures settled just below $1600 the day of expiration you would lose the full $10,500 invested whereas if you had owned the futures contract at $1600 and it settled at $1600 the day of expiration you would have broken even on the trade. Futures and options have a time component involved in each trade in the sense that each trade has an end point (date) by which whatever you were hoping for the underlying product to do must come to fruition by that date. ETF's can be held for longer periods of time and do not succumb to the value of time that is embedded in options strategies. The question is, if you feel strongly about something going on in the markets are you willing to risk more in order to get more? The options strategy discussed above is basically over a 3 month time horizon but can be implemented over longer or shorter time periods with different dynamics affecting the value of the trade.

There are an inordinate amount of outcomes based upon where the price of gold is at time of expiration but I will show you one other as an example vs. the ETF. If gold settled at $1650 at expiration and we offset our futures at that price then using the options strategy an investor would have made $4,500 profit ($1650 - our breakeven price of $1635 = $15 x $100 for every dollar move in gold x 3 contracts you own =$4,500). So if the futures price in gold settled at $1650 instead of $1700 then conceivably GLD would have gone from $155 to $160 leaving a profit of $325 ($5 made x 65 contracts). Again this is one of many possible outcomes as well as losing money if the trade does not go your way but again you can see the value of owning the commodity vs. the ETF even in terms of dollar value invested if the trade goes the way you are anticipating.

There are also other ways to attack this trade using futures and or options including going short gold if you think it is depreciating instead of appreciating. You can contact me at any time about anything I have written here or any questions you may have. I have included a simple line chart of gold that dates back to 2004 as a barometer for the general trend happening in gold.

Risk Disclaimer: The opinions contained herein are for general information only and are not intended to provide specific investment advice or recommendations and are not tailored to any specific investor's needs or investment goals. You should fully understand the risks associated with trading futures, options and retail off-exchange foreign currency transactions ("Forex") before making any trades. Trading futures, options, and Forex involves substantial risk of loss and is not suitable for all investors. You should carefully consider whether trading is suitable for you in light of your circumstances, knowledge, and financial resources. You may lose all or more of your initial investment. Opinions, market data, and recommendations are subject to change without notice. Past performance is not necessarily indicative of future results.