Why Are Commodities More Volatile Than Other Assets?
An asset is a property or something of value. Many tangible and intangible things are assets but in the world of investing and trading, there are classes of assets. For those who invest or trade their capital, the volatility of an asset is a critical concern.
Volatility is the price variance of an asset over time. The wider the price range from low to high on a daily, weekly, monthly, or longer-term basis the higher the volatility and vice versa. Some assets tend to be more volatile than others and it is often the variance of a market that makes it attractive or unattractive to market participants that have different risk profiles. When considering which asset to invest in or trade, one of the most important considerations is its variance.
Volatility: A Trader’s Paradise but an Investor’s Nightmare
Those assets that have a higher degree of volatility tend to attract those who are active traders rather than investors. When the price of an asset is highly volatile, it attracts more speculative and short-term trading activity. Therefore, markets with high price variance tend to be a trader’s paradise yielding opportunity in the immediate future while at the same time an investor’s nightmare, as investors tend to seek steady earnings through either capital appreciation or yield.
When it comes to the most popular markets that a wide addressable market of participants employ to grow their nest eggs there are different classes from which to choose. Stocks, bonds, currencies, and commodities are the four most popular classes that offer varying degrees of volatility.
The equity asset class includes shares in companies as well as indices that reflect volatility in the overall stock market or various sectors within the equity class. Investing or trading in the equity market is by far, the most popular choice for investors.
While not all stocks have the same volatility, those in major indices like the Dow Jones Industrial Average or the S&P 500 tend to experience similar variance or beta over time. Of course, there are periods where stock prices will move dramatically. The stock market crash of 1929, 1987, and the global financial crisis of 2008 are some examples of times where stocks have moved dramatically lower. Most recently at the beginning of 2016, the S&P 500 index moved 11.5% lower over a six week period because of contagion from a selloff in the domestic Chinese equity market.
As the U.S. is the most stable economy in the world, U.S. stocks tend to be less volatile than others around the world. When it comes to volatility in the S&P 500, the quarterly historical volatility of the E-Mini S&P 500 index tends to be under 10%. Over the past two decades, it has ranged from lows of 5.35% to highs of 27.23% following the 2008 financial crisis.
Bonds are debt instruments that offer a yield or coupon. Each government around the world issues bonds as do companies. Bonds are a form of financing or borrowing for countries and businesses. Investors and traders who are active in the bond market look at different periods along the yield curve. Very long-term bond investors tend to look for a stream of income while short-term debt instruments can be more volatile.
In the United States, when it comes to government debt, the central bank or Federal Reserve controls the very short end of the yield curve. The Fed Funds rate is the interest rate that banks and credit unions lend reserve balances to on an overnight basis. The Open Market Committee of the U.S. Federal Reserve controls and dictates the Fed Funds rate. The discount rate is the minimum interest rate set by the Federal Reserve in the U.S. for lending to other banks.
While the central bank controls the Fed Funds and Discount rate, the prices of bonds and debt instruments with further maturities are a function of market forces. The short-term rates can influence the medium and long-term rates, but divergences often occur.
Bond traders often take long or short positions depending on their view of interest rates. A long bond position is a bet that rates will decline while a short position takes the view that rates will move higher. Most bond traders will position along the yield curve, short one maturity and long another on spread to take advantage of pricing anomalies. Investors in the bond market look for a safe and consistent yield for their investment nest eggs. Quarterly historical volatility in the U.S. government 30-year bond market has been in a range from 6.22% to 17.5% for more than two decades. Volatility moved higher in the wake of the 2008 financial crisis.
The dollar is the reserve currency of the world because the United States is the richest and most stable economy on earth. Currency volatility tends to be lower than most other asset classes because governments control money printing and its release and flow into the global monetary system. The volatility of currencies is dependent on the stability of a government. Therefore, the dollar trades at lower volatility than the Russian Ruble, the Brazilian real, or other foreign exchange instruments that are less liquid and less likely to be reserve currencies held by governmental treasuries around the world.
The quarterly historical volatility of the dollar index dating back to 1988 has ranged from 4.37% to 15%, but the norm is a reading below the 10% level.
Commodity volatility tends to be the highest of the asset classes described in this article. The quarterly volatility of crude oil has ranged from 12.63% to over 90% since 1983. The range in the same metric for natural gas has been from 22.56% to over 80%. On a shorter-term basis, the natural gas variance has exceeded 100% on multiple occasions.
Quarterly historical volatility in soybeans has ranged from around 10% to over 75% since 1970, and the range in corn has been from just under 12% to around 48% over the same period. Quarterly volatility in the sugar futures market has ranged from 10.5% to 100%, and in coffee futures, the range has been from 11% to over 90%. In silver, the range has been from around 10 percent to over 100 percent.
Finally, gold is a hybrid commodity. As central banks around the world hold the yellow metal as a reserve asset it has a dual role as a metal or commodity and a financial asset. Therefore, a range in quarterly volatility from 4% to over 40% since the mid-1970s reflects the hybrid nature of gold prices. As the examples point out, commodity volatility over time is high and there are myriad reasons why commodities are more volatile than other assets.
5 Reasons Commodities Are More Volatile
As assets, commodities have attracted investor interest over the years but that activity tends to come during bull market periods. Over the past decade the introduction of new market vehicles that trade on traditional equity exchanges, ETF and ETN products, have increased choices for market participants. Prior to their introduction, the only avenue to invest in commodities for those without a futures account was through ownership of the physical commodity or via equity positions in companies that are producers of the raw materials.
For most, commodities have been alternative investments but for the traders of the world, the heightened level of volatility often makes them the asset of choice when it comes to short-term trading opportunities. Commodities are more volatile than other assets for five main reasons:
The equity, bond, and currency markets attract a massive amount of volume each day. Buying and selling in these asset classes have grown over the years to staggering numbers. However, many commodities that trade on the futures exchanges offer much less liquidity or trading volume than do the other mainstream assets. While oil and gold are the most liquidly traded commodities, these markets can become highly volatile at times given the potential for endogenous or exogenous events.
2. Mother Nature
Mother Nature determines the weather as well as the natural disasters that occur around the world from time to time. An earthquake in Chile, the world’s largest producer of copper, might cause a spike in the price of the red metal. A drought in the United States might cause the prices of corn and soybeans to skyrocket as crop yields decline.
We saw just that in 2012. A cold and frigid winter season increased demand for natural gas sending the prices of futures contracts for the energy commodity skyrocketing. In 2005 and 2008, Hurricanes hit the Louisiana Coast of the U.S. and damaged the natural gas infrastructure causing the price of futures to rise to all-time highs. These are just a few examples of how acts of nature can cause massive volatility in commodity prices.
3. Supply and Demand
The major determinate for the path of least resistance for raw material prices is supply and demand. Commodity production occurs in areas of the world where the soil or climate supports crops, where reserves are present in the crust of the earth, and extraction can occur for a cost that is below the market price. Demand, on the other hand, is ubiquitous. Almost every human being on planet earth is a consumer of commodities which are the staples of everyday life. Therefore, the supply and demand equation for raw materials is what often makes them some of the most volatile assets in the world when it comes to prices.
Because commodity reserves exist in specific areas of our planet, political issues in one region often affect prices. As an example, when Iraq invaded Kuwait in 1990, the price of crude oil doubled in the weeks that followed on the nearby NYMEX and Brent crude oil futures contracts. When the President of the United States released oil from the strategic petroleum reserve (SPR), the price proceeded to half in value.
Additionally, wars or violence in one area of the world can close off logistical routes, like the Panama Canal, which makes it hard or impossible to transport commodities from production areas to consumption zones around the world. Tariffs, government subsidies, or other political tools often change the price dynamics for a commodity which adds to volatility.
The traditional route for trading or investing in commodities is via the futures markets. Futures offer a high degree of leverage. A buyer or seller of a futures contract needs only to make a small down payment or good faith deposit, margin, to control a much larger financial interest in a commodity. Initial margin rates tend to be between five and 10% of the total contract value for a commodity. Therefore, the leverage in commodity futures afforded to traders and investors compared to other assets is much higher.
Commodities tend to be the most volatile asset class. Understanding and monitoring volatility is an important exercise for investors and traders alike. When determining the risk versus reward profile of any asset, volatility is a statistical measure that will help define parameters.