The Risks of Commodities
A risk is often synonymous with commodities. Most people who are not involved in the commodity business believe that the prices of commodities are wild bucking broncos, and they are often correct. Only a small portion of the population understands commodities and is willing to participate in the speculative arena.
However, volatility and risk create opportunities for profits. In losses laden with risk, the potential for losses are great, but so are the possibilities for profit. The masses often misunderstand the risks inherent in the commodities markets.
A Risky Proposition
The main reason why commodities are a risky proposition is that they trade on futures markets that offer a high degree of leverage. A commodity trader normally only has to post 5% to 15% of the contract value in futures margin value to control investment in the total contract value.
For example, if the price of crude oil is trading at $82 a barrel and crude oil futures contract is for 1,000 barrels, the total value of the futures contract is $82,000. A trader might only have to post about $5,100 to control $82,000 worth of crude oil. For every $1 that crude oil moves, that trader could potentially earn or lose $1,000 per contract held.
Crude oil can move more than $2 during a trading day. $2 higher or lower equates to a 40% move when compared to the margin necessary to trade the crude oil futures contract. Therefore, the risk of commodity futures is what attracts some and keeps others far away. Leverage can be dangerous in the hands of an undisciplined trader. Leverage is the main reason, so many new commodity traders lose money. Small traders who are new to the market tend to lose money quickly.
The professional seasoned commodity veterans in the business have mastered these volatile and leveraged markets. Commodity Trading Advisors (CTA’s) tend to achieve positive returns because of their experience in the managed futures arena. The Barclay CTA Index highlights that CTA’s earned an average compound annual return of 11.56% for the period between 1980 and 2009. CTA's had three losing years, and the worst drawdown was –1.19%.
The CTA statistics illustrate that while commodities are risk-laden for the small trader, market professionals have been able to demonstrate consistent returns with large pools of money, and they can control the risk through diversification and time-tested trading strategies. In the end, commodities can be treacherous or just another investment that often offers above-average returns.
Risks, Rewards, and Volatility
A reward is a direct function of risky. In the world of commodities, greater rewards come with a higher degree of risk. Commodity futures are leveraged instruments; it takes a small amount of margin to control a large amount of a commodity. Therefore, a trader or investor can make a lot of money, but they can also lose a lot.
Commodities are the most volatile asset class. It is not unusual for the price of a raw material to half, double, triple or more over a very short time. Stocks, bonds, and currencies tend to have lower variance and more liquidity than commodities.
For example, the daily volatility of a currency like a dollar tends to be lower than 10% while the same metric for a commodity like natural gas tends to be above 30%. Commodities are risky assets. Therefore, good judgment, caution, and knowledge about the instruments that you are trading or investing in are of particular importance in the commodities futures arena.
In any market, the biggest risk is not having a complete understanding of the business. Each business has risks. Credit risk, margin risk, market risk, and volatility risk are just a few of the many risks people face every day in commerce. In the world of commodity futures markets, the leverage afforded by margin makes price risk the danger on which most people focus.
The Balance does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.