How to profit from falling commodity prices

The most common type of investment is the long position, where we purchase something – a commodity, a share, a stock option, an oil painting, or something else – with the expectation that it will increase in value. We buy it today and hope to realize a profit buy selling it at some point in the future when it has attained a higher market price.

But how do we go about if we have good reasons to believe that something is about to decrease in value? Is there a way to profit from this hunch?

In the field of commodities, there are a lot of factors that can impact the market value of a commodity and a skilled and observant trader can pick up on trends and events that are likely to cause a drop in market value for a specific commodity.

The most commonly utilized method for making a profit from falling prices is to go short. Instead of taking a long position, you take a short position. However, taking a short position is considerably more risky than taking a long position. With a long position, the risk is limited (you can never lose more than the purchase price + transaction costs) while the upside is virtually unlimited (the market value can soar to record-breaking heights). With a short position, the risk is virtually unlimited while the upside is limited. Why? Keep on reading and you will find out more about the possible gains and pitfalls of going short.

Selling short

Let’s assume that you believe that the price of SPDR Gold Shares (GLD:US NYSE ARCA) is about to drop. You borrow 100 shares from your broker when the price is 120 USD per share. You then immediately sell these shares for 120 USD x 100 shares = 12,000 USD.

Then you sit back and wait. Your hunch was right and the share prices begins to creep down. When it is down to 100 USD, you go out on the open market and purchase 100 shares. You pay 100 USD x 100 shares = 10,000 USD.

You give back 100 shares to your broker and pocket a nice 2,000 USD profit. Of course, from this profit you must deduct transaction fees etc before you can know exactly how profitable the trade was.

Unlimited risk – limited reward

As stated above, selling short comes with limited reward and virtually unlimited risk.

Let’s take the example above, but change the outcome. You believed that the share price would drop, but in this scenario it didn’t. Instead, it started to go up. When the broker contacts you and request that you give back the 100 shares you borrowed, the share prices is at 145 USD. In order to give back the shares to your broker, you must purchase 100 shares for 145 USD per share, which costs you 14,500 USD. You only got 12,000 in payment when you sold 100 shares, so you have lost 2,500 USD + transaction fees etc.

The scary thing here is that there is no cap for how high the share price can go. Let’s say something incredibly strange happened to the market and the share price rose to 400 USD. Now buying 100 shares to give back to the broker will cost you a whopping 40,000 USD.

At the same time, the possible profit is limited. You sold the 100 borrowed shares for a total of 12,000 USD. Now, the share price sinks like a stone. When it is time for you to give back the shares, they only cost $0,50 each. You buy 100 shares for a total of $50 and make a $11,150 profit. Even though the shares became nearly worthless, you still didn’t make more than a $11,150 profit. There is a limit to how large the profit can become. Even if the shares had become completely worthless you would still not have made more than a $12,000 profit (minus transaction costs etc).

Shorting commodities

Despite the risks associated with selling short, it can still be a tempting – and highly profitable – endeavour. Here is one example of how you can go about if you believe that a commodity is going to decrease in price:

  1. Set up a margin account with your broker and deposit money or other accepted assets into it. This is necessary to be allowed to borrow from the broker. Check up in advance how much interest rate you will be forced to pay on the margin balance; you don’t want that to come as a surprise.
  2. Find an exchange-traded fund (ETF) that is tracking the commodity.
  3. Borrow ETF shares from your broker.
  4. Sell the ETF shares at the current market price.
  5. Wait for the price of the ETF shares to drop. Buy ETF shares and return them to your broker. You pocket the difference.

Inverse ETFs

If you don’t want to go short, the inverse ETF is an interesting alternative. An inverse ETF that tracks a commodity is set up to move in the opposite direction of the commodity. With a well-balanced inverse ETF tracking a commodity, each decrease in commodity price will be mirrored by an increase of the ETF value.

Proportional inverse commodity ETF: This ETF is set up with the aim of letting a 1% drop in commodity price yield a 1% increase in ETF value.

Boosted inverse commodity ETF: This ETF is set up with the aim of letting a 1% drop in commodity price yield more than a 1% increase in ETF value. Many boosted inverse commodity ETFs will go up 2% for each 1% drop in the commodity

Investing in inverse ETFs is a way of profiting from falling commodity prices without some of the risks associated with going short.

Examples of inverse ETFs:

  • United States Short Oil (NYSE:DNO
  • PowerShares DB Gold Short ETN (NYSE: DGZ)
  • PowerShares DB Gold Double Short ETN (NYSE: DZZ)