Outright Long/Short Speculation: Next time you are at a party and someone asks what you do for a living, tell them

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1 Page 1 Next time you are at a party and someone asks what you do for a living, tell them you are a commodity trader. You are likely to get a look back that conveys a sense of - that sounds impressive, I don t believe you and I have no idea what that means anyway. The truth is that there are many different types of activities that would fit nicely under the umbrella of commodity trading. In this article, we will look at some of the most common types of commodity trading. You will soon discover that while all commodity traders love to talk about their view of the market, quite often price direction in their respective commodities has little or nothing to do with how they make their money. But let s begin with the classic stereotype of a commodity trader, where forecasting price direction is the name of the game. Outright Long/Short Speculation: The tour de force of commodity trading is outright speculation on price direction. This is the high adrenaline world of George Soros, Paul Tudor Jones, Julian Robertson and the like. Traders in this camp bet on the price of a commodity increasing by going long and bet on the price decreasing by going short. They don t really care which way prices move, as long as they are on the right side of it. There are many examples of short term success in outright long/short speculation, but examples of long term success and longevity are hard to find. Outright long/short speculators use various means to predict market direction including fundamental analysis, technical analysis, market sentiment indicators and other less seemly ways to finesse the market. These types of traders often trade outright long/short positions in combination with other types of spread and option-based strategies (discussed below). An increasing amount of program trading is occurring, where buy/sell signals are generated by computer-based algorithms and trades are executed instantaneously. Brokerage: The other end of the commodity trading spectrum when it comes to price risk, are the brokers. A pure broker gets paid a commission for buying or selling a commodity on behalf of a customer, but does not take ownership of the commodity or any of the associated price risk. For example, a commodity futures broker will take orders from

2 Page 2 his or her customers to buy or sell a particular commodity futures contract. While they do bear some risk, such as messing up the order or having the customer default on a margin call, they take no price risk on the position. You might remember the scene from Trading Places where Randolph and Mortimer are explaining Duke & Duke s brokerage business to Billy Ray Valentine: Commodity Merchandising Flat Price: The third major category of commodity trading is commodity merchandising, where the trader is buying and selling a particular commodity in an attempt to earn a trading margin. They are typically taking physical ownership of the commodity and thus are exposed to commodity price risk. One of the worst, but highly useful, terms in the commodity world is flat price. Merchandising a flat price commodity involves buying or selling a commodity for which there is no readily available hedge, thus the trader is fully exposed to changes in the commodity price, or in other words has flat price exposure. The term flat price trading is used mainly to distinguish it from basis trading, where hedging is used to offset a large portion of the price risk (more on that below). It has nothing to do with the price being flat in the sense of being non-volatile. An example of flat price commodity merchandising is a grain company that buys flax from farmers and merchandises it to various buyers in North America or abroad. Since there is no viable hedging instrument for flax, the grain company s main means of managing their price risk is to attempt to back-to-back their trades to the extent possible. In other words, they buy smaller volumes from farmers and as they accumulate a position they sell to a customer, thereby reducing the amount of time they have long or short price exposure. The flip side is also possible, selling a larger volume to a customer and buying from farmers and other traders. This is not an exact science, as it is rarely possible to perfectly match up both sides, but experienced traders can manage this risk quite nicely. While there is usually more risk associated with flat price merchandising, the margins are also normally quite a bit wider to compensate for this additional risk. Flat price merchandisers will also utilize cross hedges such

3 Page 3 as related futures or a cash market at a different geographic location (track, FOB or CIF) to protect from larger adverse price moves. A variation on the flat price commodity merchandiser is a company that, in addition to flat price merchandising, also performs some form of value-added to the commodity along the way. A good example of this would be a Canadian pulse processor, which buys pulses from farmers, provides some valued-added such as cleaning, sorting, bagging, and then sells the processed product to various customers. These types of companies typically try to back-to-back their trades to the extent possible, but will also occasionally take a long/short position based on their view of the market. Commodity Basis Merchandising: Basis merchandising refers to commodities that have a viable hedging instrument and the standard practice of the merchandiser is to hedge their cash positions so that they are always essentially even (i.e., neither long nor short). An example of basis merchandising is a North American grain company that buys corn, wheat and soybeans from farmers and then sells them to various customers in North America and abroad. The basis merchandiser will use the available corn, wheat and soybean futures contracts to hedge their price risk as they are buying and selling the cash commodities in order to lock-in their trading margin. It is important to understand that the cash price and futures price are usually not perfectly correlated and the residual risk is referred to as basis risk. When a basis merchandiser uses the futures market to hedge their price risk, one could say they are exchanging flat price risk for basis risk. This is desirable because normally the flat price is much more volatile than the basis. In some cases the basis merchandiser will also have very good information about their local market which allows them to effectively trade their local basis. This is not to say that grain companies never speculate on the flat price of a hedgeable commodity, but most companies will have trading limits on their flat price and basis positions for each commodity they trade. When companies start to stray from strict basis merchandising to flat price speculation, the term hedgulating is often used tongue in cheek. Commodity Processors (End Users): Processors that utilize raw commodities in their production process are constantly buying these commodities. While the people involved in buying these raw commodities for the company are often called commodity traders, they are really commodity buyers. An example of this would be a food company that uses a lot of sugar, vegetable oil and cocoa in their finished products. Typically their main focus will be buying these commodities at the lowest possible cost and this may involve hedging the risk associated with future purchases. As we have

4 Page 4 discussed in previous articles, designing a hedging program for these types of companies is challenging because they are constantly short the raw commodities and there is no set formula as to when or how far out they should hedge their commodity risk. Some processors operate in markets where a significant portion of their price risk can be passed on to their customers. This is most often in cases where the raw commodity comprises a large percentage of total value of the finished product, such as beef and pork products. In cases where the commodity ingredients make up a small percentage of the finished product value, such as the cost of sugar in a cake mix, the ability to pass on commodity price risk to the buyer is usually quite limited. One of the few examples where a commodity processor has the ability to hedge both their primary inputs AND outputs is the soybean crushing industry. Since there are viable futures contracts for soybeans, soybean oil and soybean meal, crushers have the ability to hedge the crush margin (although there is basis risk on each of the three legs to contend with, as well as currency risk for non-u.s. crushers). The Primary Producer: At the other end of the value chain is the primary producer the gold miner, the crude oil producer, the farmer, etc. The primary producer usually lives and dies by the price of the commodities they produce, and of course their goal is to sell these commodities at the highest possible price. Costs of production are usually very hard to pass on to the next link in the commodity chain and primary producers are often exposed to competition from like producers around the world. Producers will often use various forms of hedging in order to try to protect against price declines and lock in a reasonable production margin. Market Makers: This is a relatively rare breed of commodity trader that is sort of a cross between a broker and a merchandiser. They do take on price risk, but their goal is typically to get rid of that risk as quickly as possible and earn a spread in the process. An option market maker, for example, will have both a standing bid and a standing offer in the market (and a spread between them of course). They will constantly be monitoring their net risk and use both the underlying futures and options to try to negate their delta, gamma, theta and vega risk (we ll explain the option Greeks in another article). Another example of a market maker would be an investment bank offering over-the-counter (OTC) swaps and other pricing products to its customers. Their goal is typically to offer products to both sides of the market in an attempt to reduce their net risk to zero, while earning a comfortable profit margin in the process. In cases where there is a related futures and/or options market, they will offset some or all of the risk directly in the futures or

5 Page 5 options market. In many cases, they will even make their OTC bids/offers dependent on the average price they are able execute in the underlying futures or options market. One of the common risks assumed by OTC market makers is rollover risk, as they are willing to offer pricing structures that extend beyond the liquidity in the underlying futures market. Spread and Option-Based Speculation: The last category we will look at is the speculator that focuses on spreads and option-based strategies as opposed to outright long/short speculation. Once again they are forming a view of the market, but rather than being a view on price direction, it will involve a view on the price spread between different months, or may involve a view on volatility in the case of options. An example of spread trading would be to buy a nearby futures month and sell a deferred futures month in anticipation that the nearby price will gain relative to the deferred month. Spread trading is generally less risky (for the same size trade), but offers less potential profit than outright long/short speculation. I have known traders that trade spreads exclusively and never go long or short outright. There are too many types of option trading strategies to even begin to talk about here, but this is essentially just another form of speculation. While we have just scratched the surface in this article, I hope this gives you some idea of the diversity and complexity of the fascinating world of commodity trading. v