Managing Risk in Commodities

Guy walking on a line over a canyon in Moab
Daniel Milchev/Getty Images

No pain, no gain. No risk, no reward. Whether you invest or trade on a professional basis or for your own account risk is a key consideration each time you enter into a transaction. Balancing risk versus the potential for rewards is perhaps the important analysis when it comes to markets. If the risk of loss is equal to the potential of gain on a trade or investment it becomes a fifty-fifty proposition.

The best traders and investors in the world always attempt to tilt the odds in their favor. Therefore, the goal should always be limiting risk while maximizing reward potential.

Before one can manage risk, they must understand the concept. Risks come in many forms when it comes to the markets. Over coming months, I will be writing articles on specific risks in the markets that traders and investors in the world of commodities need to understand and analyze. This article will focus on the macro issue of risk provide insight into the topic. Most dictionary definitions of risk are asymmetric, or unequal in some respects. The general definition of risk is the possibility of suffering misfortune or loss. In business and finance, we know that one cannot achieve a return without some degree of risk. Therefore, a neutral definition of risk is the exposure to an uncertainty. In the world of banking and finance, huge teams of professionals work day and night to assess, quantify and define mitigation strategies for risk.

A deep understanding and identification of the sources of risk or uncertainty, the interaction of certain risks with other risks and a plan for mitigation of those pitfalls is an essential part of investment and financial calculus. While risk is normally associated with adverse outcomes, it technically relates to any uncertainty of outcome.

Risk depends upon where one sits. The risks for an investor are different from the risks for a trader. The risks for a commodity producing company are different from those for a consumer of the same commodity. The risks for a financier are specific to the activity of that party. If an investor goes long or short there is risk -- financial and otherwise. On the financial side, a long has different risks than a short in that for the long the price of an asset can only drop to zero so there is defined risk. In the case of a short, risk is truly unlimited as the upside risk can be infinite. This is a dramatic example, but it serves as a basic example of the science of risk management.

In fact, there is a galaxy of risks and each transaction is always laden with pitfalls. The differentiation of risk includes a vigorous assessment of potential issues. One example is market risk versus credit risk. Market risk is the potential for the price of an asset moving in the opposite direction from your position; if you buy an ounce of gold, you risk money if the price goes down. If you sell short a bushel of soybeans, you have a financial risk if the price moves higher. Credit risk occurs in terms of the potential for non-performance from the party with whom who enter into a transaction with.

If you buy that ounce of gold, the price goes up and the party on the other side of the transaction refuses to deliver it is not the market risk but the credit risk that costs you money. If you sell those soybeans to someone else, the price goes lower and they refuse to buy the grain from you, the credit risk causes the loss. These are assessed risks.

An example of a non-assessed risk would be reputational risk. In the examples above, the party who does not deliver the gold or does not buy the soybeans may avoid losses however; due to their actions, they may not be able to find anyone to do business with them in the future. They harmed their reputation by the action they took.

Risk is an important component of business, whether you operate a multibillion-dollar business or just trade and invest for your own account.

Watch for a series of articles in the future addressing the world or galaxy of risks.