Trading Strategies Using Commodities
A huge trading opportunity lies in the world of commodities. Let us discuss some trading strategies using commodities as the asset class.
Arbitrage means buying and selling the same underlying in 2 different markets. This strategy guarantees a risk-free profit.
For example, Gold is selling for ₹48500 at MCX and Gold Mini is trading at ₹48505 at MCX. I can buy Gold for ₹48500 and sell Gold Mini at ₹48505 on MCX, locking in a cash flow of ₹5 without taking any risk.
Arbitrage opportunity generally exists in markets where trading occurs infrequently, or there are no transaction costs.
A market which is highly liquid and transparent, and where there are significant transaction costs, commissions, etc. will see little to no arbitrage opportunities.
A spread strategy is created when a trader tries to profit from the difference between the bid and ask spread. of an underlying.
An example would be to trade between the contracts of different sizes, Gold Main and Gold Mini at different sizes.
In a spread strategy, the underlying is the same, but the instruments through which the underlying is purchased or sold are different.
The price movement of the underlying is not relevant in this strategy. Instead, the movement in the spread of that underlying is way more important.
There is a risk of a spread expanding or contracting involved with this strategy.
Calendar Spread is a form of spread strategy.
A calendar spread involves buying and selling a futures contract of an underlying at the same strike price but at different expiration dates. The goal here is to profit from the mispricing between 2 contracts of different periods.
Buy a Gold futures contract at ₹16000 on 27th Jan 2021.
Selling a Gold futures contract at ₹16200 on 27th Feb 2021.
Here the contracts are traded on the same day, but the expiries of the 2 contracts are assumed to be different. The risk involving a calendar spread strategy is quite low, hence the profit generated from this strategy is generally not very significant.
Spread moves because of movement in the price of underlying which affects the price of a contract.
Higher the difference, higher are the chances of generating profits by using this strategy.
From the above image we can see that the difference in OI traded between Nov and Dec starts to get big from 11/21/2020, indicating that this strategy can now be used.
This is an extremely short-term trading strategy where the target is to earn 1-2 ticks over and above the transaction cost with a stop of 1-2 ticks.
This strategy involves extremely high-frequency trading.
Price movements are predicted by:
- Analysing the market depth by evaluating the buyers and sellers and their respective appetites.
- The idea is to trade by evaluating the behaviour of existing buyers and sellers in the market.
The most important parameter for jobbing are transaction costs. Jobbing is impossible when transaction costs are high.
Also, high transaction cost reduces the depth of a market, and makes the participants move out. This makes the model risky.
Example of cost of trading in Crude Oil:
- The total cost of trading ₹750 per crore.
- Value of one lot of Crude – ₹550000.
- Thus, total value to be traded – ₹550000*2 i.e., 1100000.
- Cost of Trading – 750*1100000/10000000 i.e.,₹82.5.
- Each tick movement of crude would give ₹100.
- Thus, net saving realised in one tick – 100-82.5 i.e.,₹17.5.
- Typically, one should realise at least 2 times of cost per tick, else, every trade will reduce the chances of making profits. For example, for every bad trade, profits will be reduced by 100+82.5 = ₹182.5. This means to recover your losses, you have to make 11 more profitable trades, which is unlikely.
Technical Based Trading:
This strategy involves trading using various technical analysis tools.
Depending on the trading duration, selection of the chart duration which will be used for making decisions is required.
One can use classical methods and trade more discretionarily, or one can use the modern method and trade using a trading model.
The above image is of a chart. A trader can look at various charts and make profits by correctly predicting the price movements of a stock.
This strategy involves taking opposite positions in two commodities, that is, a long (bullish) position in one commodity and another short (bearish) position in another commodity.
The objective here is to make money on the relative price movements of the 2 underlying.
The risk here is that the prices of two stocks might go up at the same time or vice-versa. Or, the two stocks might both go down, but the stock you are short can drop more than the stock you are long on or vice-versa. One half of the pairs trade may be profitable, and the other half of the pairs trade may lose money, but the goal should be that the profits should exceed the losses.
To identify a pair, there should be:
- Similarity in fundamentals.
- Deviation from mean prices.
Some classic pairs:
- Gold and Silver
- Silver and Copper
- Gold and Crude Oil
- Lead and Zinc
- Soya Bean and Soya Oil
Example: Gold and Silver
This graph shows the similarity in movement in gold and silver prices with minor fluctuations.