Risk Associated With Commodity Futures Trading

There are various risks in commodity futures trading, they are:-

Operational risk

The risk that, errors (or fraud) may occur in carrying out operations, in placing orders, making payments or accounting for them.

Market risk

It is the risk of adverse changes in the market price of a commodity future.

Liquidity risk

Although commodity futures markets are liquid mostly, in few adverse situations, a person who has a position in the market, may not be able to liquidate his position. For E.g.. a futures price has increased or decreased by the maximum allowable daily limit and there is no one presently willing to buy the futures contract you want to sell, or sell the futures contract you want to buy.

The Various Risk Management Techniques Used in Commodity Futures Trading

Considering the risks discussed previously, various risk management techniques are used in order to minimize the losses.

There are mainly 3 techniques, they are

1. Averaging

2. Switching

3. Locking

Averaging

Averaging is a technique used when there is an existing position, and the price moves adversely. And then at that particular price, enter into a similar new position. Then take the average of these 2 prices. And when the price moves to that price liquidate the position.

Example:

1. Silver bought 1 lot@ 580 cents, expecting price to go up, with cut loss @ 577 cents

Price goes to 574 cents,

Buy another new lot @ 574 cents

Now, the average price is 577 cents.

When the price comes to 577 cents, then liquidate both the lots and thus

Profit = 3 cents

Loss = -3cents

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Net profit 0

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2 .Sold soybean 1 lot @780 cents

Sold soybean 1 lot @790 cents

Sold soybean 1 lot@800 cents

Now, average price is 790 cents, when price comes to 790 cents, liquidate all 3 lots, thus making no profit no loss.

Switching

Switching is yet another risk management technique, when, there is an existing position, and the prices move adversely and gives all indication that it will go in the same direction for still some while. Then we have to liquidate the first position and enter a new and opposite position at the same price.

Example:

Bought silver 1 lot @580 cents

Cut loss@ 578 cents

Price reaches @800 cents

Then sold 2 lots of silver @ 577 cents, one lot will be liquidating the first lot, and then the second one will

be a new position.

Now when price goes to 570 cents, liquidate the second lot, and book the profits.

Profit = 7 cents

Loss = (-) 3 cents

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Net profit (+) 4 cents

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Locking

Locking is yet another risk management technique, where, when there is an existing position, and the prices move adversely and give an indication that it will move in that direction, but it will come back to its original position. Here two processes are involved ‘locking and ‘unlocking’.

It is the process where there is an existing position, and the price moves adversely, we ‘lock’ by entering into a new opposite position. And then when the second price reaches a point where it will bounce back, we ‘unlock’ by liquidating the second position and book profits, and then finally when the pr ice reaches somewhere near the first position, liquidate the position, whereby we can minimize the loss.

Example:-

Bought silver 1 lot @ 600 cents----(1)

Price falls to 590 cents

Sold silver 1 lot @ 590 cents----(2)

Price goes to 580 cents; where it is expected to bounce back, liquidate the second lot.

Bought silver 1 lot @ 580 cents, liquidation (2)

Price comes to 597 cents, then liquidate the (1) lot

Sold silver 1 lot @ 597 cents, liquidation (1)

Profit = 10 cents

Loss = (-) 3 cents

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Net profit (+) 7 cents

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Analysis

There are different types of risks involved in commodity futures trading.

The most important one being, market risk.

But to counter these price risks, various types of risk management techniques are used in order to minimize the risk.

Among the risk management techniques, locking is the most commonly used one.

Manipulation of price of the commodity is not possible as, these are global commodity prices, and in order to do so, he has to pump in huge volumes of money, which is very unlikely.

Interpretation

Although there exists various types of risks involved in trading the various risk management technique can be effectively used in order to minimize the loss due to adverse price movements.