Commodity Trading Risks - How to Manage Volatility?

Commodity trading refers to buying and selling various commodities which include everything from crude oil and gold to industrial metals like copper. However, the fluctuations of the commodity market often give rise to several risks that may impact your portfolio. These are collectively known as commodity trading risks or the potential for losses owing to volatility in prices and several other factors that may affect the values of commodities that you’re trading.

Commodity trading risks, however, can be mitigated or managed through several strategies. That’s where the importance of risk management comes into play for profitable trading, helping lower these potential losses and scaling up potential gains. 

The world has seen many such commodity market crashes that have led to catastrophic situations for investors.

For example, in 2015, it so happened that prices of almost all major commodities including crude oil and metals like copper and iron ore witnessed a sharp drop. The segment had to deal with arguably the lowest prices since the earlier financial crisis. Crude oil came down below $40 for a barrel, a first since 2009, with the Bloomberg Commodity Index coming down to its lowest level ever since 1999. There were two such freefall days before prices finally started plateauing, driven majorly by oversupply and weaker demand for natural resources. This is just one instance of how risks can erode value and investor confidence. Let’s learn more about these risks below. 

Major Risks in Commodity Trading 

As mentioned above, there are various commodity trading that you need to be aware of. They include: 

Price Volatility Risk

In this scenario, commodities remain volatile owing to imbalances between supply and demand. Think of the devastating crude oil price crash in 2020 or simply how prices of gold witness sharp spikes in inflationary times. Prices may be influenced by several other events like natural disasters, economic circumstances, geopolitical events, and more. Sudden swings in prices may lead to unexpected losses for traders, particularly those who did not hedge their positions. So, for someone holding a long position, a sudden oil price drop may lead to severe losses. This is perhaps the most fundamental/basic risk that anyone faces in the commodity market. 

Market Risks

If you’re trading in commodities, you’ll have to contend with market volatility in commodities as well. There may be several global economic indicators or market conditions that affect prices of commodities. Recessionary scenarios also lead to lower demand for industrial metals and various other commodities, while oil price fluctuations are usually the first result of any geopolitical instability. These market risks are intrinsic to trading in this segment. 

Liquidity Risk

This is one of the biggest risks in commodity trading. It may lead to losses in a situation where any commodity cannot be easily sold or purchased and you have to exit your position swiftly. Some commodities may have lower trading volumes, making this exit tough. For instance, some rare metals such as palladium may have lower liquidity levels in comparison to crude oil. It’s a risk that arises in a niche commodity market. 

Credit Risk

This risk crops up whenever one party in the transaction does not meet his/her obligations. Take the example of futures contracts, where a party does not deliver the commodity or its cash value, leading to a loss for the other party. This means a risk of default while trading with counterparties in futures contracts essentially. Take a commodity broker who does not meet the margin requirements. 

Interest Rate & Currency Risk

You will observe that commodity prices are often denominated in U.S. dollars (USD), meaning that a stronger dollar will lead to commodities becoming costlier for foreign buyers. On the other hand, hikes in interest rates may lower speculative commodity demand as well. This is because it directly impacts the financing cost for commodity producers and traders. Higher borrowing costs make it difficult to buy commodities as a result. In the first scenario, i.e. currency risks, it can pan out in different ways. Suppose an importer from Europe purchases oil at USD and the Euro suddenly strengthens against the former. This means that the oil cost will come down and vice versa. 

Regulatory & Political Risk

Commodities may be impacted directly by Governments imposing tariffs, taxes, and even export bans on the same. Take India’s restrictions in 2022 on wheat exports as an example. In a similar way, any political instability, trade war, or Government policy change may disrupt the commodity market, leading to massive fluctuations in prices. Suppose there is a big conflict in a region which produces a particular commodity in large volumes. It will naturally lead to spikes in prices and issues with supply levels. 

Weather & Natural Disasters Risk

There are always risks related to natural disasters and weather to deal with too. Agricultural commodities such as sugar, wheat, coffee, and others are heavily dependent on the weather. So, consider how wheat production in Russia was affected by droughts, making the commodity costlier and supply scarce, impacting traders in the market considerably. 

Speculation & Leverage Risk

Excessive speculation may lead to major market crashes, just like it happened in 2008. The huge oil bubble (crude oil touched $147 per barrel) eventually burst and the market crashed, with severe implications for commodity traders. Leverage magnifies not just the gains, but also losses, making it tricky for investors. 

There are also commodity derivatives risks to factor into the equation. They are tools enabling investments in commodities and potential profits without actual ownership. The derivative derives value from the underlying asset or physical commodity that it represents. 

Risk Management Strategies in Commodity Trading

Commodity trading risk management is essential in order to mitigate and tackle all the risks mentioned above. Here are a few strategies worth noting. 

Hedging with Futures & Options 

Hedging  is an effective and common risk management tactic. Futures contracts are used (they agree upon a predetermined future date for transacting any asset) to lock-in prices. This lowers risks, with the expectation that prices on commodities will go up down the line. At the same time, options may also offer downside protection for commodity investors. 

 Diversification

The age-old principle of not keeping all your eggs in one basket comes into play here as well. Trading multiple commodities will lower your overall risk exposure and spread out the risks. For instance, you can invest in a cyclical commodity like oil and also gold which is perceived as a safe haven by investors. 

Stop-Loss Orders & Position Sizing

Another risk management strategy in the commodity market is setting a stop-loss order strategically. This will help prevent excessive losses in case of major fluctuations. For example, you can set a stop-loss order to automatically exit the trade in case the price of crude oil goes below $70 a barrel. You should also calculate the position size by working out and dividing the risk per trade by the risk per share. 

Analyzing Macroeconomic Indicators

Macroeconomic indicators hold a wealth of insights regarding commodity prices and possible fluctuations. You should regularly track interest rates, GDP growth, and inflation for predicting commodity trends. For example, whenever there is higher inflation, gold prices automatically get a boost. Higher rates of interest may reduce commodity prices due to lower demand (on account of costlier borrowing). GDP growth, on the other hand, may enhance both demand and production, making commodities costlier and vice versa. You can also dive deeper into supply and demand analysis and trends for various commodities along with seasonal trends and the like. 

Avoiding Overleveraging

Overleveraging (when you borrow too much capital relative to your account balance and increase risk exposure) will naturally increase risks for commodity futures. For instance, a 10x leveraged trade in crude oil may completely wipe out your account in case of a small movement in prices. Leverage only what you can afford to lose and use diversification and stop-loss orders to reduce your risk exposure. 

Case Study: How Market Risk Affects Commodity Prices

For an understanding of commodity trading risks and how they suddenly arise, take the example of the 2020 crude oil crash. This is what actually happened: 

• The COVID-19 pandemic led to a major impact on demand and supply worldwide, leading to a huge crude oil price crash. 
• Oil prices turned negative for the first time in history, majorly owing to poor demand and continued oil production or oversupply. 
• The crisis was further exacerbated by the price war between Russia and Saudi Arabia who increased output and further flooded the market. 
• Crude oil prices came down 50% (monthly) between January and March, touching the historic low in April. Some benchmarks even traded at negative levels. To put it into context, Brent crude oil prices closed at $9.12 per barrel on 21st April, 2022, as compared to $70 per barrel at the start of the year. 
• This crisis showed how market risks may lead to severe commodity price volatility, with traders learning a key lesson- proper hedging strategies may have limited their losses in this case

Regulatory Framework for Managing Commodity Trading Risks

There are global regulatory frameworks in place for managing these commodity trading risks, as outlined below: 

Concluding Notes

Knowing about all these commodity trading risks is crucial if you’re planning to enter the commodity markets in the future. It will help you take proper risk management strategies to mitigate/lower potential losses arising out of these events, while instilling the habit of thoroughly analyzing macroeconomic indicators and other trends for better commodity price predictions. On that note, here’s to successfully carrying out commodity market trading with proper knowledge, insights, and guidance.