Should You Use Commodity ETFs?

Futures Trading Isn’t for Everybody

Until quite recently, trading futures without a futures account was impossible and that was a problem for a lot of investors.

For one thing, most brokers require a minimum of around $50k in a futures enabled account. That’s a lot of capital to tie up.

Then there is the risk involved. One contract of CL, the main WTI futures contract, represents 1,000 barrels of oil. That means that every penny move is worth $10 on just one contract. That can quickly add up in the crude market, where daily moves are frequently measured in dollars, not pennies.

That’s great when a trade is going your way but not so much when it isn’t.

The Solution

Now though, there is an alternative for those without $100k or so to sit in an account and who can’t, or just don’t want to, risk thousands a day in the volatile energy markets…Commodity ETFs.

They are funds that use futures to attempt to track the movements in commodities but are traded on the major exchanges, so they can be easily bought and sold like stocks.

They are available for the two commodities that Oil Price Alerts will focus on, crude oil and natural gas, and there are funds that are bullish (they make money when the price of the commodity rises) and bearish (they show a profit if the price goes down). Some are a simple one-for-one reflection of moves in the underlying commodity, while some employ leverage to multiply returns.

Leveraged ETFs

These funds use the inherent leverage in futures to multiply moves in the commodity. They are available with 2x and 3x leverage, so if crude were to move 2% on a given day, the 3x leveraged ETF would in theory move 6%.

I say “in theory” because these funds have high fees and expenses that make an exact multiplication impossible. Those fees are cumulative, so the longer you hold the position, the greater the effect.

You may have seen articles maintaining that those high fees make leveraged ETFs completely unsuitable for anyone but professional traders. That argument can be summed up in two words…condescending bullshit!

It assumes that you as an investor can’t understand the effects of fees and cannot assess whether they are worth paying to give you leveraged access to commodities. You should presumably just allow others to make decisions about your wealth.

The assumption I make with Oil Price Alerts is the exact opposite. I assume that there is nobody better qualified and more motivated to make decisions about your money than you.

My job is to explain the risks, and if you understand the risks leveraged ETFs provide you with great opportunity.

What You Should Know Before Buying A Leveraged ETF

1: They are Leveraged:

I know that’s a statement of the obvious, but it and its implications must be fully understood.

The potential for magnified profit also means the potential for greater losses. That means that good position management is essential if you trade leveraged ETFs. Stop-loss orders should be placed at the time a trade is initiated and more importantly still, should be adhered to

 2: They Are Not for Long Term Holding:

The fee structure mentioned above does have one measurable impact that can’t be avoided no matter how aware of it you are.

The management and other fees eat away at the price of the fund’s shares over time, making them unsuitable for a “buy and hold” strategy over long periods. I use them for swing type trades as well as intraday, but with a maximum holding period of a month or two.

3: They Are Not Free to Trade:

These days most online trading platforms advertise commission-free trading, usually in equities and ETFs.

If you read the small print, however, you will find that the ETF offer applies only to specific, named funds. I have yet to find one that includes leveraged commodity ETFs in their commission-free list.

Most Popular Energy Commodity ETFs

Unleveraged

These funds offer a simple, one for one investment in energy futures. The risks are less than leveraged funds but so are the potential rewards.

USO: Bull US oil fund that tracks WTI futures

UNG: Tracks natural gas futures

DNO: Inverse, bear oil fund. Goes up when oil goes down

Leveraged

UWT: 3x Bull Crude Oil Fund 

DWT: 3x Bear Crude Oil Fund

UGAZ: 3x Bull Nat Gas Fund

DGAZ: 3x Bear Nat Gat Fund

There are others available that offer different leverage (say 2x) or have different issuers, but these are the ones that I find most useful.

Conclusions

Oil and gas ETFs are a great way for any trader or investor to trade oil and gas futures without the expense or hassle of actually trading futures, whether they are looking to trade intraday, capture longer term swing moves or hedge existing stock positions.

You must understand the risks, but when you do, they should be a part of every trader’s arsenal.

Cheers,

M

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