Evaluating a Covered Call ETF based on commodities can be tricky, especially if you aren’t familiar with the quirks of the commodity markets.
Examples of commonly traded commodities are corn, cocoa, wheat, cotton, wool, lean hogs, crude oil, propane, gold, platinum, palladium, copper, and rubber.
You are unlikely to find a Covered Call ETF that is actually storing vast amounts of cotton, gold bars or any other commodity in their office. Instead, the fund covers its call options buy investing in various financial instruments linked to these commodities.
Before one invests in a commodity based Covered Call ETF, it is a good idea to learn a bit about commodity trading and commodities exchanges. At commodity exchanges, the bulk of trade is usually made up by futures contracts on commodities.
In economics, a commodity is an economic good that has full or substantial fungibility, and where the price of a commodity is wholly or mostly determined as a function of its market as whole. The most commonly traded commodities in the world today have well-established spot market, and a wide range of derivatives have developed that makes it even easier to gain exposure to commodity prices without actually buying and selling any physical goods.
Many of the heavily traded commodities on the world market fall into one of these categories:
- Agricultural products (e.g. cocoa, coffee, sugar)
- Metals (e.g. gold, silver, platinum)
- Energy (e.g. fossil oil and fossil gas)
If you want to gain exposure to the price of a commodity, there are many ways to go about it, and each choices comes with its own benefits and drawbacks. An interesting aspect of the commodity derivatives market is that some of the players here do not belong to any of the standard trader groups. They are not chiefly looking to make a profit from derivatives; they are instead using them as a way of hedging their economy against commodity price swings. This is for instance true for many farmers who use commodity derivatives for risk-management. Farmers who focus on growing one or a few cash crops have a strong exposure to commodity prices and often wish to reduce this risk. Another important group are producers who rely heavily on certain commodities, e.g. chocolate bar manufacturers who need to buy large amounts of cocoa and car manufacturer in need of certain metals.
Here, we will briefly look at a two examples of how it is possible to gain exposure to a commodity or commodities without actually buying, owing and selling commodities.
Exchange-traded commodity funds (Commodity ETFs)
An exchange-traded fund (ETF) is a fund where the shares are listed on an exchange. Since the early 2000s, it has been possible to invest in ETF:s that specializes in tracking the price of either a specific commodity or a basket of commodities. There are also ETF:s that aim to track a commodity index or commodity futures index. Examples of well-known commodity indices are Dow Jones Commodity Index, Goldman Sachs Commodity Index, DJUBS Index, Rogers Index, and Reuters / CRB Index.
Exchange-traded commodity (ETC) securities
Exchange-traded commodity securities are a type of asset-backed securities based on one or more commodities. Commonly known as ETCs, they were created to repackage the value of commodities into a product highly suitable for exchange-trading. The performance of an ETC is typically based on either commodity spot price or the performance commodity futures contracts.
An ETC is a debt instrument (note) and the commodity serves as collateral for it. The collateral can be a single commodity, but commodity baskets are also a popular choice.
Most ETC:s are structured to track the price of the commodity (or commodities) in the same direction as the commodity, but there are also inverse ETC:s where the goal is for the ETC to move up when the commodity price moves down and vice versa. The inverse ETC is a convenient way to invest when you think the price of a commodity will drop.
Inverters who want to increase risk can opt for a leveraged ETC (normal or inverse). The leveraged ETC is structured to multiply each movement of the underlying commodity by a specific factor, e.g. 2x or 3x. This makes it more volatile than the underlying commodity price.