On Monday, Brent Crude Oil for March delivery climbed 1.6 per cent to US$101.01 per barrel, the highest settlement since September 2008 as continued political unrest in Egypt pushed the benchmark contract past the key psychological threshold. Similarly, Light, Sweet Crude Oil for March delivery rose 3.2 per cent to US$92.19 per barrel on the New York Mercantile Exchange, the highest settlement since October 2008.

Though Egypt isn’t a major global oil producer like Saudi Arabia, it is home to the Suez Canal, a key transit hub for oil and fuel shipments from the Persian Gulf to the Western hemisphere. It therefore came as no surprise that instability in the region raised concerns about supply disruptions. As a consequence, savvy investors and traders have positioned themselves to take advantage of rising oil prices.

Previously oil-company shares were the only way retail investors could gain exposure to commodities, but those days are long gone. Now, in addition to exchange-traded funds (ETFs), futures contracts present an opportunity for investors to enter the commodities market without holding the physical asset.

By definition, a futures contract is an agreement between two parties that a specified quantity of a commodity at a set price will be delivered at a specified future date. In practice however, few futures contracts are settled through delivery as many market participants liquidate their contracts or take cash settlements before delivery is scheduled to be made.

A common perception of futures is that they are risky assets. While this is true, the fact is that they are widely used as financial tools for reducing risk. Futures markets provide an efficient and effective mechanism for the management of price risks and speculators within these markets invest in commodity futures in much the same way others invest in stocks and bonds. Futures traders accept price risks from producers and users with the goal of making substantial profits. However, it is important to note that because futures trade on regulated exchanges and have clearing houses, there is no default risk in these transactions.

So how exactly do futures work? A real life example will help to illustrate. Let’s say you are a commodity producer and you have 1,000 bushels of corn to sell in three month’s time. You could either wait until harvest three months from now to sell your corn at the spot price, or you could use a futures contract to “lock-in” the price today. If you are satisfied with the price of corn today, then you will sell (or short) the appropriate corn futures contract. By shorting the contract, you are guaranteeing that you will get today’s price at harvest time. An investor who could employ a similar strategy, but using index futures. He or she would short futures contracts on a stock index, thus reducing downside risk.

Investors can enter futures contracts through most full-service brokers on margin accounts. The concept of margin trading or leveraging in commodity trading has a broadly similar effect to that achieved by trading stocks and shares. However, initial margins on commodities are generally much lower as a percentage of the value of the futures contract than a contract in shares. It is not unusual to see margins as low as 3 per cent, with the range up to 15 per cent thus generating significant leverage and the potential to reap gains from a relatively small investment.

For example, let’s assume that the initial margin to trade light, sweet crude oil on the New York Mercantile Exchange is US$12,500. If crude oil is trading at US$100 and given that one contract represents 1,000 barrels the investor would control US$100,000 of crude oil for the above margin. If futures prices on the NYMEX climb to US$115 and the investor decides to liquidate his or her position he or she would realize a profit of US$15,000 (excluding transaction costs). In the same breath, if futures prices were to plummet, to say US$90 the investor would make a loss of US$10,000 and is likely to receive a margin call to re-establish the maintenance margin. With futures contracts, margin rates are set by the futures exchanges and some brokerages will add an extra premium to the exchange minimum rate in order to lower their risk exposure. Margin is set based on risk and thus it follows that the larger move in the dollar value, the higher the margin rates.

Futures versus ETFs? While futures may be geared towards sophisticated or high net worth investors, ETFs continue to offer solid investment opportunities. However, they can be risky investments if investors do not understand the mechanics of the Funds as they make not perfectly track the underlying commodity. For example, when markets are in contango (a situation where futures prices exceed spot prices) it is critical for investors to re-evaluate their positions. For example, investors who held positions in United States Oil Fund (NYSE: USO), which invests in futures contracts for West Texas Intermediate (WTI) light, sweet crude oil were unable to fully take advantage of recovering oil prices in 2009 and into 2010 as the ETF does not perfectly track movements in spot prices.

Overall however, investors wishing to diversify their portfolios should not only consider commodity ETFs but also futures. Though both carry risks, if properly utilized, they have the potential to provide solid returns and exposure to the commodities market which drives the global economy.

Kimberly Thelwell is the Manager, Research & Analyst, Corporate Finance & Advisory Services at Stocks & Securities Ltd (SSL). You may contact her at kthelwell@sslinvest.com.