Why do market participants trade?

Investing in commodities has always been subject to greater scrutiny due to the implication that demand and supply patterns in these markets may have for the economy as a whole. The recent financial crisis has also increased the weight of investors shifting from purely financial asset classes to instruments with an underlying commodity or close proxy. Commodities are less subject to obsolescence (so they do not easily go out of market) and can be used as an inflation hedge. Among commodities, precious metals (like gold) have always played a larger role in the economy as a mean to protect value against inflation and have become an alternative to currency accumulation, especially in a world with low returns (IMF, 2012). Investing directly in commodities is, however, very costly due to the unpredictable factors that can change their price patterns and the amount of cash that is needed to cover daily margin calls for marked-to-market futures positions. Transferable securities, instead, can be held for long periods without any margin to be posted (unless they are purchased through

Hedging is, perhaps, the investment objective that has received most attention over the years. Futures markets were originally designed to accommodate the needs of commodities users and producers that wanted to hedge their business from the various risks linked to commodities. An example of a hedging strategy is the case of a trading firm that buys cash wheat and hedges the exposure to the physical commodity (to be delivered) in the period between the purchase and actual delivery to a buyer. Hedging can be short or long, as long as there is an immediate price risk to be protected, whether the commodity is physically held or not (e.g. electricity). Hedging activities can generate significant benefits (see among others, Heifner, 1972 and Peck, 1975), and there are several forms of commercial hedging (Working, 1962):

Arbitrage hedging is not classical hedging but covers the commodities user or producer from the exposure caused by the divergence between the futures price and the spot price. The strategy

predicts convergence between the two prices and positions the investor to benefit from predictable changes in the basis and to avoid any impact on the main hedging operation. Operational hedging is the classical hedging strategy, where the futures position facilitates commercial business by temporarily substituting a cash market transaction, so providing flexibility to the day-to-day operations as well as protection from price risk. Anticipatory hedging is the purchase or sale of a futures contract by a commercial firm in anticipation of a forthcoming cash market transaction.

Selective hedging is done to avoid any risk on the transaction, so it should not provide any gain but simply protection over the completion of the operation. This hedging can certainly take various forms, either long or short positions. It is usually done to cover business operations from volatility risk.

Finally, the pure ‘risk-avoidance’ hedge avoids unnecessary risk-taking by another position that is primarily based on information about future price trends rather than a specific physical exposure. This hedging is not usually done by the classic commodity firm, but by portfolio managers that want to diversify their portfolio. It often overlaps with ‘informed trading’ (see below).

Box 4. Case study: corn storage hedge

An example of a combined anticipatory and operational hedge is a corn storage hedge (Bunge, 2012). The user (or a producer collecting harvests from small regional farmers) in June wants to anticipate hedging the risk of storage from November (when he/she will buy the physical commodity) until March, which is the next available month for delivery. A large crop is expected (so large inventories and the spread between December and March is reasonably high).

The commodities firm buys the spread between December (the closest available date to the November harvest as in November the cash market is inactive) and the March futures contract, by selling the futures contract in March and buying the futures contract in December in case the crop is not large enough. For this transaction to be possible, the spread should be higher than the actual storage cost from November to March. Typically, the distance in time embeds this cost. When November comes, the commodity firm buys the corn from regional farmers and compares the spread with the March delivery.

It should still realise a profit from the spread over the storage cost of keeping the commodity from November to delivery in March. Unwinding the futures position (spread) will produce additional costs, but the likely net gain of the hedge would remain positive (see below and Bunge, 2012).

Buy the spread:

Sell CH (corn futures with maturity in March) at 580 Buy CZ (corn futures with maturity in December) at 550

Gain put on spread: 30 (historically in June is 20; another reason to do the hedge)

If the harvest is disappointing and demand for storage space reverts to normal, the hedge will be beneficial.

The November outcome:

Sell physical corn for March delivery at 595 Buy physical corn in November spot market at 575 Revenue on physical transaction: 20

If the crop is larger the gain should be higher, but if there is a hedge you have the same net result. So hedging does not necessarily give unpredicted high returns, but allows the commodity firm to stabilise earnings over time and predict trends.

Other trading objectives

Another trading objective is generated from the need for liquidity/funding relief. Positions may be taken to meet specific regulatory requirements, or be due to increasing margin requirements that can no longer be met by the commodity firm. Both situations may cause some level of trading that is not justified by other investment strategies. Some new commodities indexes, structured as exchange-traded funds, are used by financial institution as liquidity relief (De Manuel and Lannoo, 2012), but their size is still small if precious metals and crude oil are not included (see Section 1.3). Spotting a divergence between futures and spot price at maturity is the classic example of arbitrage. If the futures price at maturity is lower than the spot price (beyond the spread between the two due to delivery costs), the commodity firm will exploit this situation by buying the futures rather than the spot. This type of trading is developed in all asset classes once an opportunity arises to generate returns without risk. The important aspect of this transaction is that this is a risk-free operation.

Informed trading, also known as ‘speculation’³⁰, is a form of trading based on investments in private (non-inside) information, which the trader exploits to generate profits. Speculation is different from market manipulation, whereby the trader exploits inside information that is used illegally. It is important that the term ‘inside’ is properly defined to understand the distinction. Informed trading can be split into two main categories:

1. Trend spotters.

2. Index investing.

The first category includes several strategies aimed at anticipating the trend in future or spot prices. Among these, there are three important trading styles for commodities: a legal form of

‘scalping’; position trading; and ‘spread’ trading. Scalping is a different form of market making where the trader (through the use of advanced technologies, such as high-frequency trading) ‘makes’ the bid-ask spread by exploiting small changes in the bid-bid-ask spread through trading tick sizes. This trading activity should provide liquidity and reduce the size of the bid-ask spread. Technological advances are making it more stable even in highly volatile market conditions, with limited liquidity withdrawal under volatility. Position trading is the classical ‘trend spotting’ strategy, using private information (e.g. research, whether from a newspaper article or a complex statistical model) to predict how the future curve will move and take a position accordingly. Finally, spread trading is an attempt to gain from the differences between future contracts with different maturities or commodities, by recognising specific price patterns. For instance, March contracts may be historically low in relation to those expiring in May, net of carrying costs and interest foregone. Other categories of spread trading deal with strategies to gain from transactions across similar commodities, by exploiting seasonality factors.

Index investing, whether for funding or informed trading, involves a significant new class of trader that has important differences with the classical informed trader, mainly taking long positions through indexes for long periods of time (see Section 1.3.3).

Informed trading can involve three types of analyses: fundamental analysis, which looks at the general fundamental aspects of the market (including political aspects); technical analysis, which follows patterns on complex charts; and quantitative analysis, which uses complex statistical models to identify trends and profit from them.

Table 16. Comparing investment objectives

PROs CONs

Hedging Risk protection and predictability Costly

Funding Liquidity relief Indirect costs on operations

Arbitrage Risk-free gain and price efficiency Occasional Informed trading Investing in information, which flows into prices Risky

Source: Author.

30 This term is often used in a pejorative sense. However, the latin term speculare means ‘to look forward’, i.e. to use available information (legally acquired) to estimate where is the trend going and to benefit from it.

An important difference between informed trading (or speculation) and gambling is that speculation allows existing risk to be transferred to those that claim they can handle it, while gambling is new simply unnecessary risk. Informed trading allows new pieces of information (whether low or high quality³¹) to be channelled into prices, thus increasing the efficiency of price formation mechanism (Grossman, 1977; O’Hara, 1995). Publicly available information (or its interpretation) may be also wrong, but this noise increases the incentives for traders with good information to trade on the market and so bring in good information, which would not be the case for a market with fully-informed participants. This would be beneficial even though investors may bet on the continuation of the trend while the process of re-alignment to fundamentals goes on, and temporarily shift prices away from fundamentals (through herding), at a high risk of being caught in the re-adjustment process (De Long et al., 1990; Vansteenkiste, 2011). However, excessive information may also discourage investments in information if there is not sufficient return. It would deteriorate the quality of price formation. It seems highly unlikely, therefore, that informed trading would drive prices in liquid markets significantly away from fundamentals, as long as it is not the result of information that is not correctly priced by all market participants (such as the spillover effects of prolonged expansionary monetary policy operations) or it is an attempt at manipulation (see the next section for early empirical evidence). Even if trading activity were to drive prices away from fundamentals, it is not in the nature of such trading to hold long-term equilibrium based on low-quality information, unless for manipulation purposes (which is a different topic). This is particularly true for commodities futures markets, where positions are marked-to-market on a daily basis, so prolonged positions in futures markets without any link to fundamentals cannot be held for long without the involvement of significant amounts of cash to keep margins at maintenance level and so high risk.