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Chapter 6

Trading, Hedging and Speculating in Commodities

Index of Contents:

USING COMMODITY FUTURES FOR TRADING IN COMMODITY FOR PRICE MOVEMENTS

Commodity futures traders can take a long or short futures position either for squaring up or for delivery. Quite often, traders can trade a commodity with a time frame of as low as a few days to as high as a few months. In that case, they may have to take the delivery and hold the delivery for the period.

For example, Brent Crude prices moved up from $85 in November 2018 to $51 in January 2019 and then back to $71 in April 2019. That is a huge trading opportunity giving nearly 40% on the short side and another 40% on the long side.

In such cases, it works economical for the trader to take position, bear the delivery, storage and insurance costs and still make a decent profit margin. A trader is different from the speculator in the sense that the speculator does not intend to take delivery of the commodity at all. Traders are also different from hedgers because a hedger will typically have an underlying position which they are trying to protect against unfavourable price movements. The trader is open to squaring off a trade and also to take delivery as long as there is sufficient profit in the position to make a margin after meeting all costs.

USING COMMODITY FUTURES FOR SPECULATING IN COMMODITY FOR PRICE MOVEMENTS

Speculators are the commodity market participants who attempt to profit from price change in futures contracts. A speculator does not have the intention of taking delivery of the underlying commodity. Speculator does not have the perspective of a trader but is purely looking at short term swings in the price of the commodity. Since the speculator does not intend to take delivery, they will hold the futures position only within the contract tenure and square off at the first opportunity.

Speculators trade based on their educated guesses on where they believe the market is headed. For example, if a speculator believes that a commodity is overpriced, he or she may short sell the stock and wait for the price of the stock to decline, at which point he or she will buy back the stock and receive a profit. Speculators are vulnerable to both the downside and upside of the market; therefore, speculation can be extremely risky. Speculators use a mix of fundamental triggers, technical charts, news flows and macros to take a view on the market. Speculative trades in commodities could be triggered by any of these factors.

  • Technical charts of commodity prices and volumes may be throwing up exciting opportunities for trading within a band or trading bounces from supports or reverses from resistances. This is the most common approach of speculators. Such speculators also try to trade larger movements by using technical breakout signals on the price.
  • There are also macro speculators who rely on broad macro data with implications for commodity prices. For example, excess supply of cotton from Egypt could lead to a pressure on cotton prices in India and that could induce speculators to short cotton futures. Most commodities are driven by macros as that is what normally determines the forces of demand and supply.
  • Triggers for speculators can also be news driven. Commodity prices are driven by the forces of demand and supply and hence any trigger or news flow that impacts the demand / supply equation can be a useful trigger for the speculator. Most of these are very short term triggers to speculate without delivery.

Quite often speculators are considered to be adding volatility in the commodity markets. Actually, the speculators play an important role and contribute in making the markets safer for the traders and the hedgers. Here is how.

a) Speculators provide liquidity to the markets by constantly trading in and out of the markets. This is useful in creating volumes and making the markets safer and less vulnerable to price shocks.

b) Speculators also work as market makers as they trade on small spreads and keep churning. Hence speculators are normally available on the buy side and the sell side. This adds value because hedgers are normally available only on one side of the trade.

c) Since speculators are constantly trading in and out of the market, they ensure that spreads in the market are narrow and the basis risk is reduced, thus making the commodity safer to trade in the futures market. This again reduces the market risk for all participants, including for trader and the hedgers in the market.

USING COMMODITY FUTURES FOR HEDGING COMMODITY PRICE RISK

Major participants in the futures markets are corporates, proprietary desks of brokers, HNIs, dealers, wholesalers etc. Both producers and consumers of commodities look to mitigate risk through the use of hedging. Most participants in the commodity market are “hedgers” who trade futures to reduce the risk of financial losses arising from price changes.

Hedging is about taking offsetting positions. For example, if you have gold in you inventory and need to supply the gold to a jeweller in the marriage season, you can lock your risk by selling higher gold futures. It not only gives you a locked in return but also helps you profit in the downside and compensate for your losses on the long position. Hedging eliminates the volatility in the price of an asset. Unlike speculation, hedging tries to cut the amount of risk or volatility associated with a change in the price of a security. Here are some specific characteristics of hedgers:

  • Hedgers are seen as risk-averse and speculators as risk-lovers. That is because hedgers have an underlying position in the commodity either as a producer, supplier or as a consumer and that is what determines their hedging needs.
  • Hedgers reduce their risk by taking an opposite position in the market to what they are trying to hedge. That means that there is a trade-off for the hedger because when you hedge you limit the profit potential. But the main purpose of hedging is not to make profit but to bring certainty to the business by limiting risks.
  • The ideal situation in hedging would be to cause one effect to cancel out another. This can either happen on the short side or the long side. The offset would work perfectly because on the settlement date, the spot and futures price converge to the same price.

Example:

Let us take the live example of a jeweller who specializes in making high end designer jewellery and hence delivers on a per order basis. Let us also assume that it has a major contract due in six months, for which gold is one of the company's main inputs. The company is worried about the volatility of the gold market and believes that gold prices may increase substantially in the near future. To protect itself from this uncertainty, the company could buy a six-month futures contract in gold. This way, if gold experiences a 10 percent price increase, the futures contract will lock in a price that will offset this gain. Even if the two contracts are not fungible, the profit on the gold futures will compensate for the notional loss on the spot position.

There are two sides to the hedging story. Although hedgers are protected from losses, they are also restricted from any gains. The portfolio is diversified but still exposed to systematic risk. Depending on a company's policies and the type of business it runs, it may choose to hedge against certain business operations to reduce fluctuations in its profit and protect itself from any downside risk. The basic idea of hedging is not to make profits on trading but to protect the business risk.

SPOT-FUTURES ARBITRAGE IN USING COMMODITY FUTURES

Arbitrage refers to price differentials. An arbitrage could basically take any of the 3 forms in the commodity markets.

  • Arbitrage between the spot market and the futures market
  • Arbitrage between two markets for the same commodity
  • Calendar arbitrage between two different monthly contracts

Arbitrage between spot and futures market

This is the most common type of arbitrage. In this case, the trader or the arbitrageur tries to capture the price difference between the spot price and the futures price. The spot futures arbitrage on commodities can be extremely profitable but it also involves taking delivery of the commodity in the spot market and selling futures against that. So there is investment in the form of commodity holding in spot, the insurance and warehousing charges, the margin on futures and only after all these considered does the spot-futures arbitrage becomes profitable. There is a catch here. Spot markets on commodities are not governed by SEBI and the exchange only facilitates the transfer and delivery of the commodity. Only the futures are regulated by the SEBI. As a spot-futures arbitrageur, you are exposed to dual regulation.

Arbitrage between two different commodity markets

In this case, the arbitrage does not happen between the spot and futures but between the futures prices between two markets. For example, if the cotton futures are quoting at a different price on NCDEX and the MCX and if the price differential is substantial then one can look buy in the exchange where it is priced lower and sell on the exchange where it is priced lower. Here the risk is not too high as both trades are under the SEBI purview. However, with high levels of automation in online trading, such arbitrage opportunities do not last for too long.

Calendar arbitrage between two monthly contracts

This is also popularly referred to as a calendar spread. In this arbitrage you consider two different maturities for commodity futures in the same exchange. Such opportunities occur quite often since the commodity market gives fairly wide price fluctuations.

UNDERSTANDING RISK-REWARD RATIO WITH RESPECT TO COMMODITY DERIVATIVES

Risk reward lies at the base of commodity futures trading. What do we understand by risk-reward ratio? It is like a cost benefit and measures the return per unit of risk. Take a simple trade with a stop loss and profit target. If you stop loss is Rs.2 below and your profit target is Rs.6 above, then the risk/reward ratio is 3:1, which is fairly attractive. Normally a risk reward ratio of 2 and above is considered to be adequate although you can opt for lower risk-reward ratio if your win probability is relatively higher.

What you need to know about the risk reward ratio

Risk reward ratio is mathematically quite simple and can be measured as the quotient of two price differentials. Basically, the reward risk ratio measures the distance from your entry to your stop loss and your take profit order and then compares the two distances in relative terms. Let us look at the key steps in this regard.

  • First step is to calculate the RRR (Risk Reward Ratio). Let’s say the distance between your entry and stop loss is 50 points and the distance between the entry and your take profit is 100 points. Then the reward risk ratio is 2:1 because 100/50 = 2.
    Therefore the Risk Reward Ratio Formula can be written as under:
    RRR = (Take Profit – Entry) / (Entry – Stop loss)
  • The second step is the most important step of calculating the win rate. When you know the risk reward ratio for your trade, you can calculate the minimum required win rate. Why is this important? Because if you take trades that have a small RRR you will lose money over the long term, even if you think you find good trades.
    Minimum Win rate = 1 / (1 + Risk Reward Ratio)
    If you enter a trade with a 1:1 reward/risk ratio, your overall win rate has to be greater than 50% to be a profitable trader. Here is how the calculation goes.
    1 / (1+1) = 0.5 = 50%
    Let us now look at the necessary win rate for different risk-reward ratios
    Win Rate 25% 33% 40% 50% 60% 75%
    Minimum RRR 3:1 2:1 1.50:1 1:1 0.70:1 0.30:1
    Traders need to apprehend that you neither need an extremely high win rate nor a large risk reward ratio to profit as a trader. As long as the RRR and your historical win rate match, your trade stands a very good chance of being in the money.
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