Back to School on the Futures

The Nuts and Bolts

Commodity-futures trading involves an agreement by the investor to purchase or sell a commodity for delivery in the future:

1. at a price that is determined at initiation of the contract;
2. that obligates each party to the contract to fulfill the contract at the specified price; and
3. which may be satisfied by delivery or offset, which means liquidating the futures trading position before delivery.

ETFs generally are set up to achieve the same rate of return as a particular market index. Similar to an index fund, an ETF will invest in either all of the market segments or a representative sample of the market segments included in the index. For example, Spyders(SPY Quote) invests in all of the stocks contained in the S&P 500.

Commodity-based ETFs can be volatile trading vehicles, but they also are easily accessible and don't have the high leverage that futures markets do. That means returns from ETFs may not match those that can be achieved through futures trading, but they also don't match futures' risks. Generally, ETFs carry less risk than trading in straight futures markets.

One caveat: Some newer ETFs can be thinly traded. As with any investment, make sure you understand exactly what an ETF is intended to capture and how it trades before you put your money down. New ETFs come out every day; in fact, Roger Nusbaum recently reviewed seven new commodities ETFs. With so many choices, you'll want to sift through them carefully.

One more step removed from commodities futures -- and carrying correspondingly less risk -- is the commodities investment that's probably the most prudent choice for most investors: investing in individual stocks of companies that are involved in raw commodities. Again, the downside is that returns may not be as high or as closely correlated to the aforementioned more volatile investment vehicles.

And as with ETFs, do your research; there are more factors than straight commodity prices involved with how a company can trade, though commodity prices certainly do affect how these stocks trade. Before you invest, make sure you understand how much a commodity's price move is likely to affect your chosen stock.