Why you might not want to invest directly in commodity futures

Market Realist

How to trade rising natural gas prices and falling oil prices (Part 2 of 6)

(Continued from Part 1)

Futures contracts

The most direct way to invest in natural gas and crude oil price changes is through futures contracts on the New York Mercantile Exchange (NYMEX). While trading commodities futures will result in gains or losses that most closely reflect price changes in the underlying commodity, this method may not be ideal for most individual investors—primarily due to two factors: leverage and large positions.

Leverage on futures magnifies gains and losses

Firstly, a futures contract represents a promise to either buy or sell a specific asset at a future date. Both the buying and selling party put up an initial margin, which is some fraction of the value of the underlying asset. For instance, for the front month Henry Hub natural gas contract on the NYMEX, the initial margin required is $2,530 for each contract (which represents 10,000 MMBtus of natural gas). At $4.33 per MMBtu, this represents $2,530 required to be posted for total underlying asset value of ~$43,000. If natural gas prices increased $0.20 per MMBtu to $4.53 to MMBtu, the party that’s long the contract is up $0.20 * 10,000 or $2,000 on the initial $2,530 investment. While prices only increased 4.6% (from $4.33 to $4.53), the party that’s long natural gas is up 79% (from $2,530 to $4,530). Meanwhile, the party that sold the futures contract is down $2,000 on the initial $2,530 investment, to $530. Because the required maintenance margin for this contract is $2,300, the party that sold the contract will be required to post an additional $1,770 in order to meet the maintenance margin requirement. As returns and losses can be highly magnified on futures contracts, using this method to invest directly in commodity price swings may not be appropriate for many individual investors.

Futures contracts require large minimum positions

Secondly, investing in many commodities futures requires positions that may be larger than appropriate for most individual investors. The main natural gas futures contract on the NYMEX has a contract size of 10,000 MMBtu, which at a natural gas price of $4.33 per MMBtu (as of the close of January 15, 2014) represents rights to assets worth $43,300. If an individual investor only has a few hundred thousand dollars to invest, this represents an inappropriately large proportion of the total portfolio.

“E-mini” contracts are also offered for both crude oil and natural gas futures. These allow investors to buy and sell smaller positions. For example, the e-mini natural gas contract represents 2,500 MMBtu rather than 10,000 MMBtu. However, even at 2,500 MMBtu, the notional value for one natural gas contract is still $10,000, which may be too much exposure to the commodity for some individual investors.

Continue to Part 3

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