The volatility trick to commodity trading

Traders should understand it well before taking positions

The market works like fire. A trader needs to be properly equipped before entering the arena, lest he burn his fingers. On the other hand, with proper skill sets and modern tools, a trader could tame the fire and use it to his own advantage.

Proper strategies not only lead to wealth creation for the trader, but also help the market to grow on a sustained basis. Vice versa, the lack of strategies leads to widespread value erosion, which results in people deserting the market after operating for a few months. Hence, in order to ensure their own long-term survival, it is imperative that the markets impart knowledge to participants, caution them against possible pitfalls and help them hone their trading skills.

Such a requirement is particularly more significant in case of the commodity exchanges, which have come into existence recently but have already attracted millions of traders and investors. In order to sustain the pace of growth, it is important to deliberate on the nature of trades, identify deficiencies in trading strategies that lead to loss of capital, and suggest possible solutions.

On a survey of some small traders in exchanges, it is interesting to note that many do not analyse the volatility of a commodity, leave alone work out strategies based on this.

Each underlying commodity has a different type of volatility, which may be defined as the range within which the price of a commodity generally moves during a given time period. When we say average volatility, we should not consider the extreme volatility exhibited by different commodities at certain points of time due to certain special events.
The difference in volatility in different commodities is a function of:

• Historical price behavior
• Liquidity: Volatility tends to be lower if a commodity is highly liquid and the impact cost of putting in a position is lower. Volatility would be higher if the liquidity is low.
• The number and nature of participants: Usually, volatility in the price of a commodity is lower if a large number of people participate in trading and also, the participants are from different backgrounds and have different objectives. For instance, if trading in an instrument consists of a large number of speculators only, it would be more volatile. But, if it consists of a sizeable number of investors, jobbers, arbitrageurs, hedgers, physical market traders, short-term and long-term position traders, etc.

It is important for a trader to understand all this while determining the size of the position he should build. A common mistake many traders make is to determine the position size based on the margin requirement of the commodity exchange. Two different commodities may attract the same margin, but the risk involved may not be the same vis-à-vis the same position value. Hence, though a trader may be right in taking a directional call, he may not be able to realize the full potential of that call due to inappropriate position sizing.
Hence, it becomes important for a trader to understand the inherent volatility of each commodity and accordingly determine the position size.

A trader should:

• Take smaller positions in those commodities which have got higher volatility so that he can allow the commodity price to oscillate over a larger span of price movement so that he does not get stopped out. Commodities with higher volatilities include copper, zinc, potatoes and certain other agri commodities.
• Take bigger bets in commodities which have lower volatility, so that he can take advantage of smaller movements and lock in the profits. Some such commodities are gold, silver and crude oil.

Let us say a trader wants to take a position worth Rs 50 lakh in commodities. He can take position in 5 lots gold of 1 kg each or 20 lots of copper of 1 metric tonne. The risks for the trader in these positions are totally different. Due to higher inherent volatility of copper prices, the trader is exposed to a higher risk in copper than gold. This is because the percentage movement in the price of copper on a daily basis is multiple times higher than gold.

Hence, if he takes a position of Rs 50 lakh in copper, after paying a margin of 7%, i.e., Rs 3.50 lakh, there is all likelihood that he may lose more than 50% of his capital of Rs 3.50 lakh due to a sudden movement of 3-4% in case of the price of copper. Hence, if a trader has a capital of Rs 3.50 lakh, it is advisable to take position of only Rs 10 lakh in copper contract, pay a margin of Rs 70,000 and set aside the remaining Rs. 2.80 lakh for meeting the MTM calls. If the sizing of his positions in futures is designed in such manner, he will have a better chance to get positive returns on his investment.

The problem starts when an investor with Rs 3.50 lakh capital approaches a broker and asks him how much position he can take. The broker looks at the exchange margin requirement and the margin percentage rather than inherent volatility of each commodity. The broker does not advise him based on underlying volatility that equal position values in copper and gold are actually not equal in terms of their inherent risks.

Therefore, in order to maximize returns, a trader should analyse the volatility of the respective commodity in which he wants to take a call, and then decide his position sizing. Higher the volatility, lower should be the size of his position, even if it means investing only a part of his capital towards margin.

The writer is director, Multi Commodity Exchange of India Ltd, Mumbai. The views expressed above are personal.