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After two years of amazing gains, the stock market has started to waver recently. In response, many smart investors have recommended diversifying your portfolio by investing in commodities. But as many who've invested in them for the first time have seen recently, commodities involve plenty of risk as well.
If you want to get exposure to the booming commodities market but don't want to put huge amounts of your money at risk, you have to be careful with your investments. Fortunately, there's a strategy you can use to make money from commodities without losing everything if things go sour. Below, I'll give you a couple of ways to play the commodities markets while keeping a tight grip on your risk level.
The basics: stocks vs. ETFs
Unless you want to dive into the high-risk world of commodity futures, most investors play commodities in one of two ways. Stocks of companies that produce commodities often see their shares move in tandem with the price of those commodities. So if you believe that silver has the potential to rise, then silver miners Hecla Mining (NYSE: HL ) and Coeur d'Alene (NYSE: CDE ) or silver-streaming company Silver Wheaton (NYSE: SLW ) tend to move in tandem with silver bullion prices. Similarly, natural gas producer Chesapeake Energy (NYSE: CHK ) has seen its shares rise and fall along with prospects for the natural gas market.
On the other hand, exchange-traded funds can give you direct exposure to commodity prices. In precious metals, iShares Silver ETF (NYSE: SLV ) and SPDR Gold Trust (NYSE: GLD ) own huge amounts of silver and gold, with each ETF share representing a small piece of that pie. You can find similar ETFs on a range of commodities, from oil and gas to corn and other agricultural products.
Control your risk
The challenge, though, is that commodities markets move around a lot. Just last month, silver lost more than 25% of its value in a week, after more than doubling in the previous year. When the bottom fell out of the energy markets in 2008, Chesapeake fell more than 80%.
Moreover, ETFs don't always work the way you'd expect. United States Natural Gas Fund (NYSE: UNG ) uses futures contracts to track natural gas prices, but the ETF has seen its value steadily erode far more than the price of natural gas.
But you can turn commodity volatility into profit potential. With two strategies involving options, you can make money in up or down markets.
The first strategy is called a bull call spread. The strategy involves a combination of buying one call option on a stock or ETF and selling another. By choosing options with different strike prices, you can strictly limit the risk involved as well as the potential reward.
For instance, if you think Silver Wheaton will rise from its current level to around $35, you could recently buy a September $35 call for $3.75 per share while selling a September $45 call for $0.88. If the stock rises to $45 or above by mid-September, your position would be worth $10 -- a triple on your net investment. Yet even if Silver Wheaton drops 25% -- as it did from late April to early May -- the most you can lose is the net cost of $2.87 that you paid for the position.
Similarly, if you're bearish on a commodity, you can use a bear put spread to profit from a drop. If you think gold is overvalued, then with SPDR Gold trading at $150, a put spread using September $150 and $140 puts will have a maximum risk of $3.56 per share but give you as much as $10 of profit potential.
Given how easy it is to lose huge piles of money in the commodities market, an options-based approach can help you put a lid on risk. Spreads limit your potential profit, but you're the one who chooses what those limits are -- and you also get the benefit of knowing you can never lose more than the net cost of your spread position.
Call and put spreads are just one way that Jim Gillies and Jeff Fischer help their Motley Fool Options subscribers make money. With a 96.7% success rate on their trades, you won't want to miss what else they have to say. Simply click here and enter your email address to stay up-to-date on the latest money-making options strategies.