Category Archives: Basics

Basics of Commodity Trading, Structuring, and Risk Management.

What is Commodities Trading?

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Let’s face it, Trading has got a bad reputation. Slick but arrogant Suits drinking pints of Vodka Redbulls in City wine bars. Public opinion is also clear on another point: There’s only one thing worse than a trader, and that’s a trader who works for a bank! Harsh, but sometimes, fair. Most of the time, however, traders are just normal people. Socially awkward? Yes. Arrogant? Certainly. Intelligent? Definitely. They have to be all of these things in order to succeed. It is just the nature of the beast. But why do they even exist? What’s it all about, this Trading malarkey? Well, the best way to explain Trading, and more specifically, Commodities Trading, is with a farming analogy:

A young man has just inherited a field. There is nothing on it except weeds and he has no money. He knows he can grow wheat on the field but has no finance to buy seed. Luckily, he can sell next years wheat crop now in what is known as the Futures Market. So, he sells his future crop in order to raise the money to buy the seed.

See what I did there? Not only did I give you a real world example of why the Futures Market is needed, but I also gave you a two-for-one deal by also explaining why we sometimes need to Sell Short. Selling Short confuses people because it involves selling something you don’t actually have and some even think that it is morally wrong. However, the young man who wants to start a farming business needs to start somewhere. There is no difference between selling short his future crop and asking his bank manager for a loan. Both involve risk, both involve “middle men”, and both involve getting an advance in order to buy some seed. Job done, everybody happy.

Add a few more farmers, young and seasoned, as well as a few more participants, like bakers and breweries (the consumers) and you have yourself a market all of a sudden. All willing buyers and sellers looking to do business with each other and mitigate their risks. The problem is that because the buyers and sellers have different factors that affect their businesses – farmers are dependent on the weather, whereas bakers are dependant on sandwich consumption – they may not want to be in the market at the same time or location. So, in order to close these gaps and make sure everyone gets a fair price, market makers are used. Market Makers make their money by charging a small commission on each trade they do, but even if a farmer is busy on his tractor, the baker is guaranteed a fair price when he goes to the market. The ability to buy and sell stuff easily is known as Liquidity, and it is the Market Makers’ jobs to provide liquidity.

Over the years, our young farmer has grown his successful business and works hard tending his crops. He is so busy with his daily duties that he no longer has time to go to the market himself. Luckily the man that looks after all his finances, his banker, is happy to take the farmer’s risk and buy and sell in the market on his behalf, for a small fee of course. The farmer can get on with his job without having to worry about going to the market. As an added bonus, the banker also represents other farmers as well as a selection of bakers, so putting all the risk in one basket, the banker can trade in the market at a better price and offer a more efficient service to his clients.

While all this is going on, the price of wheat is going up and down according to various supply and demand forces and someone sees that although the price of wheat looks reasonable to anyone in the wheat market, it is very high in comparison to the price of corn. Independent traders then enter the market in order to take advantage of the price difference between wheat and corn. The more traders there are in a market, the fairer the price is as it represents a more balanced view on that commodity.

That’s the theory anyway. There are always those that try to take the easy way. Those that want to make a quick killing and those that are just downright dishonest. In my 25 plus years experience of the commodities markets, something “big” tends to happen every couple of years, some bigger than others. Regulatory rules and Compliance training do work and filter out most things. However, I have found that the market tends to police itself, by and large, especially in the smaller niche markets like commodities. If someone tries to “squeeze” the market for their own gain, it doesn’t take long for the market to find out who it is and then retribution awaits. A storm in a teacup follows and then the market calms down again and we can all get on with our jobs again. Remember, there is no conspiracy. The last thing anyone wants is an unfair market. An unfair market will simply die, and everyone loses their jobs, including the farmers and bakers.

So, what have we learned?

  • Normal people trade in the Futures Markets
  • Normal people Sell Short
  • Traders are needed in order to provide liquidity
  • Bankers are not evil
  • The more market participants there are, the fairer the price: it’s called Democracy
  • Bad stuff happens but it gets sorted

Yes, it is a simplistic view, but that is what the Internet Generation is about. If you disagree, drop me a line.