One of the many great features of the trading strategies you can learn here at Trade With Precision is that they are applicable to any product and timeframe. So you are free to choose the instruments and underlyings of your preference. For most traders there will be a point in time when they are starting to get involved in trading commodities.

Futures

For quite some time trading commodities like gold, silver, oil, sugar and coffee meant that you had to have a futures trading account. Not every broker offers futures trading and the world of futures trading can be quite intimidating when you are just starting out. You have to be aware about contract and tick sizes, margin regulations, contract months and rollover procedures just to name a few. Nothing that can’t be handled, but there is definitely a learning curve involved.

CFDs / Spread Betting

Many brokers offer CFDs and spread bets on different commodities. They are usually straight forward to trade. Terms are broker dependant and you should keep in mind that your counterpart usually is your broker, where futures are settled by the exchange / their clearing house.

ETFs

In recent years a third category of products has been gaining more and more momentum. These are of course ETFs, which is the abbreviation for Exchange Traded Funds. ETFs are funds but are tradable just like any other stock. There are ETFs covering almost anything tradeable: GLD gives you easy access to trading gold, SLV for the silver market, TLT represents Treasury Bonds. With VXX you can trade VIX volatility and USO is one of the ETFs to trade if you want to get involved with oil. Interested in real estate? Have a look at IYR.

Not all ETFs are created equal

While ETFs seem to be great and easily handable trading instruments, there is one thing to be aware of which will otherwise easily screw up your trading results. You should take your time and read the ETF prospectuses your are interested in. It is crucial to understand how the fund manager manage the fund and try to replicate the underlying commodities performance. In those cases, where they use futures contracts to model the ETF  (VXX and USO for example, while GLD and SLV are not using futures), you suddenly gain exposure to one of the aspects of futures trading: you should become aware of the term structure.

Term Structure

Term structure  describes the relationship between current and future prices. There are two different situations: the market is either in “normal backwardation” or in “contango”.  Investopedia defines contango as “a situation where the futures price of a commodity is above the expected future spot price”, whereas normal backwardation “... is when the futures price is below the expected future spot price”.

The Drag & Why This is Important

The term structure becomes relevant with ETFs every time the fund managers roll their position from one futures contract to the next. This roll will either occur at a credit or at a debit. And these continuous rolls for a debit due to the term structure will result in an ugly effect known as drag: the ETF doesn’t represent the underlying commodity as you would expect at first glance, but rather is dragged down due to costs of rolling the position. Just open up a weekly chart of VXX, the short-term S&P 500 volatility index for the last five years to see the power of the drag. In order to keep these instruments tradable there is usually a reverse-split from time to time, so x shares are replaced with one share at a value-equivalent price.

Conclusion

Does this mean you should avoid ETFs when trading? Absolutely not! It would really be a pity to avoid ETFs as many great TWP style trading opportunities are waiting for you. Just make sure that you understand the instruments (remember: not all ETFs are subject to the drag!) you are using and be aware of the potential drag, that might add a grain of salt to an otherwise perfect bullish setup or just might spice up your short setups ever so slightly.

Follow the links below to register for our next live webinars:

Learn a Simple 6-Step Trading Strategy runs on

• Tuesday 7th July 2015 @ 8pm London, 3pm New York, 5am Sydney (next day), 7am Auckland (next day)

Or Alternatively (depending on time zone)

• Wednesday 8th July 2015 @ 8pm New York, 10am Sydney (next day), 12pm Auckland (next day)

Regards,

Philipp Pfitzenmaier

The TWP Team