The concept of diversification is not new to portfolio design. In stocks, bonds, and even real estate there is a general rule that diversification helps reduce risk and increase profit potential. In theory, diversification spreads your exposure among financial vehicles that have different risks and respond to different factors. For example, you might invest in commercial and residential real estate to diversify between properties that may respond to the business cycle or to consumer sentiments. Within commercial and residential real estate you can break down diversification between property types like office buildings, strip malls, retail space, town houses, apartments, individual homes, entire developments, etc.
Stock investors usually refer to “industry sectors” with gross categories like transportation, utilities, industrials, and services. These are further refined into “sector groups” like medical, computers, aviation, rail, gold mining, automotive, retail, publishing, and more. Within these groups, you can diversify into drugs, hospitals, medical devices, and alternative care for “medical.” You may break out software, hardware, internet, communications, and maintenance for the “computer” sector group.
For interest rate instruments like bonds, notes, and bills we separate by maturity, yield, commercial issues, and government paper. Within certain groups are particular types of instruments like “zero coupon” and even the “backing” behind the paper will be different.
Commodities and related options also have various degrees of diversification. Like stocks, there are specific sectors. The most generally followed are:
Within these sectors, there are specific “groups.” Here are the most common groups associated with sectors in the U.S. markets:
Agricultural – Grains, meats, foods
Metals – Copper, silver, gold, platinum, palladium
International Softs – sugar, coffee, cocoa
Industrials – lumber, cotton
Interest rates – bonds, notes, bills
Currencies – foreign exchange and Dollar index
Stock Indices – S & P 500, mini S & P, NY Index, Value Index, Nikkei, Dow Jones, Mini Russell 2000, NASDAQ
Energy – Crude oil, heating oil, gasoline, natural gas
You should notice that some “groups” represent individual commodities while others can be broken down into group members. Grains encompass wheat, corn, oats, canola, rice, soybeans, and soybean products. Meats cover live cattle, feeder cattle, lean hogs, and pork bellies. Interest rates include 90-day bills, 2-year notes, 5-year notes, 10-year notes, 30-year bonds, and municipal bonds. Foreign exchange incorporates British Pounds, Japanese Yen, Deutschmarks, French Francs, Australian Dollars, Canadian Dollars, Mexican Pesos, and Swiss Francs. (This may change with the introduction of the “Euro”)
Finally, there is diversification over time. For agricultural commodities, different delivery months represent important diversification because some contracts are base upon “old crops” left from a previous harvest while others reflect “new crops” yet to be harvested. “Spread” transactions are frequently based upon the supply and demand differences between old and new crops. For interest rates and currencies, time diversification allows traders to extend transactions over long periods or take advantage of seasonal differentials brought about by the end of fiscal years or holiday seasons.
In stocks, diversification is associated with a negative correlation between issues. The objective is to reduce risk and exposure by buying stocks that are less likely to move in tandem. If steel makers are not positively correlated with food processors, it is wise to buy each so that adversity in one will not necessarily impact the other. However, if steel is positively correlated with auto manufacturing, you would own one or the other, but not both. In theory, you avoid the risk that both stocks will be negatively affected by the same economic conditions.
In futures and options trading the logic is similar. The greater your diversification, the lower the overall risk. However, since futures and options provide profit opportunities in up and down markets with equal ease, the basis for diversifying is different than for stocks or other investments. The objective when trading futures and options is to be in the right markets at the right time… in the right posture. Clearly, not all futures markets are will trend at the same time. When prices are stable, opportunities are slack. When you are dealing with raw materials or flat interest rates, you cannot expect substantial price movement. This suggests that your objective when selecting a commodity or options portfolio is to pick diverse complexes to assure being in one or more trending markets at the correct moment.
You should keep in mind the fact that negative or positive correlation between commodities is not as important as the effectiveness of your trading strategy. Yes, corn and soybeans may move together. Buying or selling both may over weight your portfolio with positively correlated grains that can be affected by rain, exports, etc. Yet, if your strategy is able to accurately forecast both markets, the positive correlation has less significance than a similar pair of stocks. With stocks, the portfolio assumption is that you are always “long” (a buyer) looking for price appreciation.
Commodities offer several levels of diversification that can accommodate capital from as little as $5,000 to several million. A small account might start a program following one grain, one metal, one meat, and one currency. As capital grows (hopefully), an interest rate, soft commodity, and energy contract can be added. Once all sectors are represented by at least one commodity, you can move to the next diversification level with multiple commodities within each sector. Finally, you can trade multiple contract expirations for each commodity.
This simple approach provides a stepladder for growing your commodity trading program while managing risk through diversification. The COMMODEX System tracks 47 U.S. commodities with as many as 100 contract months. This permits trading with small capital or very large capital. COMMODEX is organized by complex and commodity to make the selection easy and fast. A complete explanation of portfolio design and money management comes with the COMMODEX Commodity Trading Kit which is part of the subscription service.