Is Commodity Trading Hard?
One of the most important things in #commodity #trading is dealing with market structure: an inverse or carry market.
Contrary to stock prices, there is no one price for #commodities. There are different physical delivery periods and corresponding prices, related to S&D cycles.
Storing commodities costs #money; warehousing, handling, insurance, interest. This is reflected in the price of commodity futures further out in time (in the future, hence the name)
The stock price of a company going up or down is simple to follow. In commodities you need to look at how the front delivery periods move in relation to the deferred delivery periods.
An inverted curve normally reflects strong demand for the commodity nearby, making buyers prepared to pay a higher price for prompt delivery.
A curve in carry reflects weak nearby demand. As a result, sellers prepare to discount nearby delivery to facilitate buyers to store the commodity for future usage taking into account the above-mentioned storage – carry – costs.
The mechanics and risks related to market structure are complex.
1920-1925 “On the top of the hill the wagons drive up on bridge and dump their load into the big 250 thousand bushel holder, then it runs through the pipes to the edge [sic] of the hill & they shoot the wheat into the bucket that holds 50 bushels. & it comes across river and dumps into a bin & then as you see it run into the wagons (8 horses) & then 8 miles to the elevator. Noble saved an 18 mile haul by doing this & has no bins in the field same as other farmers. His crop will bring 1 1/4 million dollars. Bucket is about 1/2 way over the river in picture.” Archives website: http://www.galtmuseum.com/archives.htm
- A well-functioning futures market reflects the physical underlying, and an inverted futures market reflects strong nearby demand. But inverted futures #markets can be caused by technicalities rather than true underlying S&D dynamics, like large positions of speculators, financing, logistics and complex physical delivery processes.
- Inverted markets, rightly or wrongly, attract speculative funds (often algos) as a reflection of strong demand, amplifying inverses, causing more speculation.
- Option gamma squeezes or other liquidity voids lead to liquidity drying up further so that a market curve becomes technical causing stress, not related to the physical underlying
- The process of cash convergence (cash commodity prices adjusting to futures to the extent that physical delivery against futures makes economic sense) is slow, complex and often painful. Remember a negative spot crude oil price during peak COVID.
- In an extreme case the futures exchange steps in to force liquidity being provided in order to retain an orderly market. Many can’t afford to wait for this. Remember the recent LME copper spectacle
- Inverses can stay in a market for long to implode in seconds “when the music stops”. Trading P&Ls can be represented incorrectly when inverses have been marked to market but not cashed.
- Hedgers’ (buyers and sellers of physical commodities who make opposite trades in futures to manage price risk) critical decision is WHERE to hedge on the curve, facing less liquidity and less knowledge about the deferred, but more risk and critically less time to act on the nearby.
- A wrong assessment of S&D cycles can be dangerous. As a futures contract at expiry is a true physical contract – a firm commitment to deliver or take delivery!
In conclusion, market structure has made and broken trading careers and even blown-up companies in spectacular fashion.
Lastly, I could write a book about it.
Written by Martijn Bron
Martin serves as the Global Head of Trading at Cargill Cocoa and Chocolate
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Is Commodity Trading Hard?