Commodities are mostly shunned by the average investor, for some reason or another. Investing in commodities simply isn’t as popular as investing in stocks (God knows why). But what many fail to realize is that investing in commodities can be far more profitable (or far more unprofitable) than investing in stocks. Let me first tell you a little bit about my experience with investing in commodities.

As you might guess, the first commodity that caught my attention was the almighty bling. Gold. It was 2008, when the “Gold 1000″ chant was raging. A habit that my mother gave me was to always take a few months to study a market before actually investing in it. So I looked at it. I looked at the technical charts. I looked at those charts some more. And based on the factors of resistance at the 1000 barrier, and an ever weakening economy, I shorted gold (actually, I shorted a gold ETF) at around 920. I held onto my short position for 3 1/2 months, and I made a bundle. My next experience with commodities was far more profitable. It was in silver. Amongst commodity investors, silver is shunned more often than gold, for reasons I don’t know. Silver’s volatility far exceeds that of gold, hence trend investors like me love the silver market. I bought 100% into silver in September ’10, and as you can guess, I more than doubled my money in the following surge in silver prices.

 

But enough with my stories. Here’s what you need to consider when investing in commodities.

The investment instrument

So how do you invest in commodities in the first place? The answer, my friend, is that there are two main ways to do so. One; invest in futures. Futures are agreements to buy or sell in the future a specific quantity of a commodity at a specific price. The futures market is very hard to invest in; many highly sophisticated hedge fund managers don’t even use futures when they invest in commodities. The second option is that you invest in a commodities ETF. That is what I do. A commodity ETF basically just tracks the price of a particular commodity or group of commodities. For example, go on Google Finance and take a look at the ticker SLV. SLV is the most widely traded ETF for silver. Go compare SLV with the actual silver price. You’ll notice that SLV does a fantastic job at tracking silver prices.

So I’ve already mentioned that investing in commodities ETFs is the way to go for if you’re interested in the commodities markets. But what I haven’t said yet is that there are many ETFs for each commodity. For example, there are tens of ETFs for the gold market. Which one should you invest in? Invest in the one that has the largest volume and largest market cap. The smaller commodity ETFs with lesser volume tend to track the actual commodity price poorly. Keep in mind that commodity ETFs are only an instrument to invest in the actual commodity itself. Hence, you want to invest in the ETF that best tracks the actual movements of the commodity’s price, which means that when investing in commodities, always invest in the commodity ETFs that have the highest volume and largest market capitalization.

Investing in commodity ETFs on the long side is ok, but investing in commodity ETFs on the short side can be disastrous.

There are two types of ETFs for all commodities. There are the long ETFs, and the short ETFs. For the gold market, GLD is a long ETF, while GLL is a short ETF. Short ETFs are also known as inverse ETFs. In short, the concept here is that if you’re investing in a commodity on the long side, you’ll need to invest in a commodity long ETF such as GLD. If you’re investing in a commodity on the short side, you’ll need to invest in a commodity short ETF such as GLL.

Now here comes the tricky part. Commodity long ETFs usually track the commodity’s price very well, but commodity short ETFs often have problems tracking the commodity’s price. For example, if you had bought GLL, and actual gold prices dropped by 5%, GLL might only drop 2% (because like I said, commodity short ETFs often have problems tracking the commodity’s price). That (plus the next part of this post) is why I usually don’t short commodities.

Commodities fluctuate far more than stocks.

A well known fact to commodity investors is that commodities tend to fluctuate (pardon my inappropriate use of language) a hell of a lot. Many commodities such as gold, silver, etc have fluctuations of up to 50% or more in a year. Commodities in general tend to fluctuate at least 30% a year. A commodity that goes up 5% or down 5% a day is considered normal.

Thus, I suggest that the average investor not to invest in commodities. When playing markets with heavy volatility, one needs to consistently be monitoring the highly volatile market. Market conditions for commodities change very fast, partially due to the high volatility and the ever unpredictable weather. Hence, it’s prudent for the average investor who monitors his or her portfolio for 2 hours a day to stay away from the commodities markets. The commodities market is not meant for the passive investor.

Because the commodity markets are so volatile, they are a short-medium term investment, which leads to my next point.

Commodities aren’t a buy and hold investment.

Since the 1970s (when commodity prices were first allowed to freely float), on average, commodities have consistently underperformed stocks. This is because the public has a common notion that rising commodity prices means rising inflation (which is true). Hence, if inflation averages 5% a year, commodities in the long term should theoretically rise 5% a year. My point is, commodities aren’t a great long term investment. Discounting the current commodities bubble, the commodities market far underperforms stocks. But there’s another reason why buy and hold doesn’t work for the commodities market, and the answer lies in volatility.

As I’ve mentioned above, the commodities markets frequently experience huge volatility. Most investors can’t stand the huge volatility. Thus, if you are to deploy the buy and hold strategy, you’d better be ready to hold onto your position, because a 50% fluctuation is very common. And believe me, most buy and hold/long term investors can’t stand a 50% fluctuation in their performance.

But the high volatility in the commodities markets attracts many traders and medium term trend investors, such as myself. The high volatility and large fluctuations offer traders and trend investors a great environment to make some spectacular back-to-back investment returns.