Commodities Trading Risks explained by professional Forex trading experts the “ForexSQ” FX trading team.
Commodities Trading Risks
If you watch the financial news or ready business periodicals and research about various asset markets, you have likely heard the terms “risk-on” and “risk-off.” Traders and investors around the world understand that a risk-on or risk-off event can have significant ramifications for the prices of stocks, bonds, currencies, commodities, and all other market vehicles that move up and down in price.
When markets are operating under normal conditions, the quest of all market participants is to increase the amount of available capital at their disposal.
Money managers and individual traders and investors will buy or sell assets to capitalize on market volatility or price movement. These market participants will use fundamental and technical analysis to determine whether they believe the price of an asset will appreciate or depreciate. They will then enter the market to either buy or sell. At times, more sophisticated money managers and traders will identify mispricing or spread trades where they purchase one asset and sell another.
To maximize returns, many market participants have turned to leveraged derivative instruments like futures, options on futures, ETF and ETN products and other vehicles to magnify returns. Leveraged products contain a greater risk but offer the potential for greater rewards.
During risk-on periods, leverage tends to increase in markets as the majority of professionals and individual investors deem the possibility of market and exogenous risks as low.
A high degree of liquidity tends to characterize risk-on periods; trading volumes increase and bid-offer spreads narrow. In highly liquid markets, it becomes easy to buy and sell or to get into and out of risk positions. The vast majority of the time, risk-on periods dominate the market action.
There are times when markets will move dramatically in one direction or the other because of either market-related or exogenous events.
Some traders call these periods, black swan events. Many professional traders employ statistical tools that measure the sensitivity of investment portfolios to market volatility. One of these tools that became popular since the 1990’s was VAR or value at risk. Banks, financial institutions, and pools of capital like hedge and mutual funds tend to use this tool which will provide insight into the performance of a portfolio during extreme periods or black swan events. VAR will test the profits and losses for a portfolio based on a market move of multiple standard deviations. This statistical metric is a measure of price dispersion from the mean or average price. In volatile markets, data points are further away from the average and in markets with less variance; they are closer to the mean. Therefore, standard deviation sheds light on historical volatility. VAR is a method that measures the potential for future volatility by looking at the history of the variance of the asset in question. A volatile asset will have a higher standard deviation than one that trades in a narrow price range. Calculating VAR is not a difficult exercise when it comes to a single asset. However, when attempting to understand VAR on a portfolio that has many diverse instruments it becomes more complicated.
A black swan event is one that causes markets to move 10 standard deviations or more in a very short time. The global debt crisis that occurred in 1997 and the mortgage-backed securities crisis in 2008 were both black swan events where markets moved dramatically. During these periods, many market participants will close all positions as they remove of risk positions. This risk-off scenario tends to occur quickly, and price movements can be dramatic because many will act at the same time. During a risk-off period, prices can move even more than the triggering event implies as liquidity declines and bid-offer spreads widen. In less liquid markets it becomes difficult and expensive to buy and sell or get into or out of positions.
In the world of commodities, risk-off scenarios can create enormous levels of volatility as commodities tend to have higher levels of variance than stocks, bonds, currencies, and other market vehicles.
Commodities often have higher standard deviations during risk-on times so when the landscape turns to risk-off the market volatility can get quite wild. As an example, the housing crisis in the U.S. caused the price of crude oil futures to drop from $147.27 per barrel in July 2008 to $32.48 by December of that year. The decline of almost 78 percent in just six months is an example of the kind of volatility that is possible during a risk-off period. Risk-off scenarios are rare but memorable as tremendous losses tend to result from these black swan events. Wars, periods of crisis, natural disasters, and other exogenous events can be the root causes of many risk-off periods through history. As these events tend to surprise markets it is difficult to prepare for them, however when they occur prices move dramatically.
Many financial institutions and regulators spend a great deal of time understanding risk and preparing for risk-off events. Individual investors should also always have a plan to protect their assets from the black swan which can destroy vast amounts of capital very quickly.
Commodities Trading Risks Conclusion
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