1. finance
2. investing
3. futures trading

2010
Northbridge Capital Asia
Azharuddin Mansiya
[ HOW TO GET RICH WITH
COMMODITIES]
1
Table of Content
Introduction
03
1) Commodities as an Investment vehicle
04
2) FAQ of commodity markets in India
07
3) Making a Trade
10
4) Learning to Trade
11
5) Trading Strategies
12

Playing with spreads

Bullish strategies

Bearish strategies

Range bound trading strategies
6) Hedging Strategies using Futures
2

Cash market hedging

Futures market hedging
24
Introduction
Many people have become very rich in the commodity markets. It is one of a few
investment areas where an individual with limited capital can make extraordinary profits
in a relatively short period of time. For example, Richard Dennis borrowed $1,600 and
turned it into a $200 million fortune in about ten years.
Nevertheless, because most people lose money, commodity trading has a bad reputation
as being too risky for the average individual. The truth is that commodity trading is only
as risky as you want to make it.
Those who treat trading as a get-rich-quick scheme are likely to lose because they have to
take big risks. If you act prudently, treat your trading like a business instead of a giant
gambling casino and are willing to settle for a reasonable return, the risks are acceptable.
The probability of success is excellent.
The process of trading commodities is also known as futures trading. Unlike other kinds
of investments, such as stocks and bonds, when you trade futures, you do not actually buy
anything or own anything. You are speculating on the future direction of the price in the
commodity you are trading. This is like a bet on future price direction. The terms "buy"
and "sell" merely indicate the direction you expect future prices will take.
If, for instance, you were speculating in corn, you would buy a futures contract if you
thought the price would be going up in the future. You would sell a futures contract if
you thought the price would go down. For every trade, there is always a buyer and a
seller. Neither person has to own any corn to participate. He must only deposit sufficient
capital with a brokerage firm to insure that he will be able to pay the losses if his trades
lose money.
In addition to speculators, both the commodity's commercial producers and commercial
consumers also participate. The principal economic purpose of the futures markets is for
these commercial participants to eliminate their risk from changing prices.
On one side of a transaction may be a producer like a farmer. He has a field full of corn
growing on his farm. It won't be ready for harvest for another three months. If he is
worried about the price going down during that time, he can sell futures contracts
equivalent to the size of his crop and deliver his corn to fulfill his obligation under the
contract. Regardless of how the price of corn changes in the three months until his crop
will be ready for delivery, he is guaranteed to be paid the current price.
On the other side of the transaction might be a producer such as a cereal manufacturer
who needs to buy lots of corn. The manufacturer, such as Kellogg, may be concerned that
in the next three months the price of corn will go up, and it will have to pay more than the
current price. To protect against this, Kellogg can buy futures contracts at the current
price. In three months Kellogg can fulfill its obligation under the contracts by taking
3
delivery of the corn. This guarantees that regardless of how the price moves in the next
three months, Kellogg will pay no more than the current price for its corn.
In addition to agricultural commodities, there are futures for financial instruments and
intangibles such as currencies, bonds and stock market indexes. Each futures market has
producers and consumers who need to hedge their risk from future price changes. The
speculators, who do not actually deal in the physical commodities, are there to provide
liquidity. This maintains an orderly market where price changes from one trade to the
next are small.
Rather than taking delivery or making delivery, the speculator merely offsets his position
at some time before the date set for future delivery. If price has moved in the right
direction, he will profit. If not, he will lose.
In his book The Futures Game, Professor Richard Teweles explains the functions of the
futures markets: "In addition to reducing the costs of production, marketing and
processing, futures markets provide continuous, accurate, well-publicized price
information and continuous liquid markets. Futures trading is [thus] beneficial to the
public which ultimately consumes the goods traded in the futures markets. Without the
speculator futures markets could not function."
Since speculators perform the valuable functions of providing liquidity and assuming the
risk of price fluctuation, they can earn substantial returns. The potentially large profits are
available precisely because there is also a risk of substantial loss.
4
Commodity Trading as an Investment Vehicle
There are many inherent advantages of commodity futures as an investment vehicle over
other investment alternatives such as savings accounts, stocks, bonds, options, real estate
and collectibles.
The primary attraction, of course, is the potential for large profits in a short period of
time. The reason that futures trading can be so profitable is leverage.
For instance, if you had Rs 5,000 futures trading account, you could trade one Gold index
futures contract. If you were going to buy the equivalent amount of common stocks, you
would currently need about $350,000, thirty-five times as much.
Let's say you decided that the stock market was going to go up. You could invest
$350,000 and buy individual stocks equivalent to the S&P index, or you could buy one
S&P futures contract. Buying a futures contract is the same as betting that the S&P index
will go up.
If you had made your move on the first trading day of September, 1996 and held your
position for two weeks, your common stock position would have been worth about
$20,000 more than when you bought it, a gain of about six percent. Not bad for only two
weeks. If you had taken the futures route, however, you would have made the same
$20,000, which would have been a 200 percent gain on the $10,000 margin required in
your futures trading account.
That is an actual example of the tremendous returns you can earn in a short period of time
trading futures. Of course, you can lose money just as fast if you trade in the wrong
direction. Suppose you had thought the stock market was about to go down and you had
sold a futures contract instead of buying one. If you had valiantly held it for two weeks,
you would have lost $20,000. That's a good example of why you must exit your trades
quickly if they start to move against you.
Another advantage of futures trading is much lower relative commissions. Your
commission on that $20,000 futures trading profit would have been only about $30 to
$50. Commissions on individual stocks are typically as much as one percent for both
buying and selling. That could have been $7,000 to buy and sell a basket of stocks worth
$350,000.
While profits can be large in commodity trading, it is not easy to make consistently
correct decisions about what and when to buy and sell.
Commodity speculation offers an important advantage over such illiquid vehicles as real
estate and collectibles. The balance in your account is always available. If you maintain
sufficient margin, you can even spend your current profit on a trade without closing out
the position. With stocks, bonds and real estate, you can't spend your gains until you
actually sell the investment.
5
As you will see, commodity trading is not particularly complicated. Unlike the stock
market where there are over ten thousand potential stocks and mutual funds, there are
only about forty viable futures markets to trade. Those markets cover the gamut of
market sectors, however, so you can diversify throughout all important segments of the
world economy.
In futures trading, it is as easy to sell (also referred to as going short) as it is to buy (also
referred to as going long). By choosing correctly, you can make money whether prices go
up or down. Therefore, trading a diversified portfolio of futures markets offers the
opportunity to profit from any potential economic scenario. Regardless of whether we
have inflation or deflation, boom or depression, hurricanes, droughts, famines or freezes,
there is always the potential for profit trading commodities.
There are even tax advantages to making your money from futures trading. Regardless of
the actual holding period, commodity profits are automatically taxed as sixty percent
long-term capital gains and forty percent short-term capital gains. The current maximum
capital gains rate is thirty-three percent, somewhat less than the maximum rate for
ordinary income. To the extent that capital gains tax rates are reduced in the future,
commodity traders will benefit. If a distinction is re-established so that taxes on longterm gains are lower than on short-term gains, commodity traders will benefit.
6
FAQ of Commodity markets in India
How do I choose my broker?
Several already-established equity brokers have sought membership with NCDEX and
MCX. The likes of Refco Sify Securities, SSKI (Sharekhan) and ICICIcommtrade
(ICICIdirect), ISJ Comdesk (ISJ Securities) and Sunidhi Consultancy are already offering
commodity futures services. Some of them also offer trading through Internet just like the
way they offer equities. You can also get a list of more members from the respective
exchanges and decide upon the broker you want to choose from.
What is the minimum investment needed?
You can have an amount as low as Rs 5,000. All you need is money for margins payable
upfront to exchanges through brokers. The margins range from 5-10 per cent of the value
of the commodity contract. While you can start off trading at Rs 5,000 with ISJ
Commtrade other brokers have different packages for clients.
For trading in bullion, that is, gold and silver, the minimum amount required is Rs 650
and Rs 950 for on the current price of approximately Rs 65,00 for gold for one trading
unit (10 gm) and about Rs 9,500 for silver (one kg).
The prices and trading lots in agricultural commodities vary from exchange to exchange
(in kg, quintals or tonnes), but again the minimum funds required to begin will be
approximately Rs 5,000.
Do I have to give delivery or settle in cash?
You can do both. All the exchanges have both systems - cash and delivery mechanisms.
The choice is yours. If you want your contract to be cash settled, you have to indicate at
the time of placing the order that you don't intend to deliver the item.
If you plan to take or make delivery, you need to have the required warehouse receipts.
The option to settle in cash or through delivery can be changed as many times as one
wants till the last day of the expiry of the contract.
What do I need to start trading in commodity futures?
As of now you will need only one bank account. You will need a separate commodity
demat account from the National Securities Depository Ltd to trade on the NCDEX just
like in stocks.
What are the other requirements at broker level?
You will have to enter into a normal account agreements with the broker. These include
the procedure of the Know Your Client format that exist in equity trading and terms of
7
conditions of the exchanges and broker. Besides you will need to give you details such as
PAN no., bank account no, etc.
What are the brokerage and transaction charges?
The brokerage charges range from 0.10-0.25 per cent of the contract value. Transaction
charges range between Rs 6 and Rs 10 per lakh/per contract. The brokerage will be
different for different commodities. It will also differ based on trading transactions and
delivery transactions. In case of a contract resulting in delivery, the brokerage can be 0.25
- 1 per cent of the contract value. The brokerage cannot exceed the maximum limit
specified by the exchanges.
Where do I look for information on commodities?
Daily financial newspapers carry spot prices and relevant news and articles on most
commodities. Besides, there are specialised magazines on agricultural commodities and
metals available for subscription. Brokers also provide research and analysis support.
But the information easiest to access is from websites. Though many websites are
subscription-based, a few also offer information for free. You can surf the web and
narrow down you search.
Who is the regulator?
The exchanges are regulated by the Forward Markets Commission. Unlike the equity
markets, brokers don't need to register themselves with the regulator.
The FMC deals with exchange administration and will seek to inspect the books of
brokers only if foul practices are suspected or if the exchanges themselves fail to take
action. In a sense, therefore, the commodity exchanges are more self-regulating than
stock exchanges. But this could change if retail participation in commodities grows
substantially.
Who are the players in commodity derivatives?
The commodities market will have three broad categories of market participants apart
from brokers and the exchange administration - hedgers, speculators and arbitrageurs.
Brokers will intermediate, facilitating hedgers and speculators.
Hedgers are essentially players with an underlying risk in a commodity - they may be
either producers or consumers who want to transfer the price-risk onto the market.
Producer-hedgers are those who want to mitigate the risk of prices declining by the time
they actually produce their commodity for sale in the market; consumer hedgers would
want to do the opposite.
8
For example, if you are a jewellery company with export orders at fixed prices, you
might want to buy gold futures to lock into current prices. Investors and traders wanting
to benefit or profit from price variations are essentially speculators. They serve as
counterparties to hedgers and accept the risk offered by the hedgers in a bid to gain from
favourable price changes.
What happens if there is any default?
Both the exchanges, NCDEX and MCX, maintain settlement guarantee funds. The
exchanges have a penalty clause in case of any default by any member. There is also a
separate arbitration panel of exchanges.
Are any additional margin/brokerage/charges imposed in case I want to take
delivery of goods?
Yes. In case of delivery, the margin during the delivery period increases to 20-25 per cent
of the contract value. The member/ broker will levy extra charges in case of trades
resulting in delivery.
Is stamp duty levied in commodity contracts? What are the stamp duty rates?
As of now, there is no stamp duty applicable for commodity futures that have contract
notes generated in electronic form. However, in case of delivery, the stamp duty will be
applicable according to the prescribed laws of the state the investor trades in. This is
applicable in similar fashion as in stock market.
How much margin is applicable in the commodities market?
As in stocks, in commodities also the margin is calculated by (value at risk) VaR system.
Normally it is between 5 per cent and 10 per cent of the contract value.
The margin is different for each commodity. Just like in equities, in commodities also
there is a system of initial margin and mark-to-market margin. The margin keeps
changing depending on the change in price and volatility.
Are there circuit filters?
Yes the exchanges have circuit filters in place. The filters vary from commodity to
commodity but the maximum individual commodity circuit filter is 6 per cent. The price
of any commodity that fluctuates either way beyond its limit will immediately call for
circuit breaker.
9
Making a Trade
Assuming you have consulted the price charts, and decided to make a trade, how does
this actually take place? You will have a trading account open with a broker. Believing,
for example, that the price of Silver will be going up in the near future, you will cal up
your broker and follow following steps: Consider today is 6th June 2010.
How to place an order
Tasks – To buy Silver July 2010 futures
Mention your client account ID to your broker
Ask him to buy 1 contract of Silver July futures @
current price (Rs 28000/kg)
Ask your broker if you have sufficient cash
balance to place the above order
Enter your stop loss of Rs 28970/kg (depending on
how much are you willing to lose in case the price
moves in unfavorable direction)
Remember your futures contract will be sold off if
the price reaches or goes below the stop loss
However, you can offset your position any time before the Silver contract expires at the
end of month. To the extent Silver's price is more than Rs 28150/kg when you offset, you
will profit by Rs150 per Kg.
How to place exit order from futures.
Tasks – To sell Silver July 2010 futures
Mention your client account ID to your broker
Ask him to sell 1 contract of Silver July futures @
current price (Rs 28150/kg)
Ask your broker to cancel any other pending
orders to sell silver July futures.
Remember by placing sell order for futures, you
would have offset your earlier buy position on the
same futures.
Similarly, you can follow same procedure to sell the futures and then offset your position
by buying the same futures contract.
Now that you have learned, how to place an order to trade in futures, it is time to learn
how to trade correctly.
10
Learning To Trade Correctly
Introduction
Another way to learn is by trial and error. This is the method of choice for most people
although they probably don't realize it. The trouble with trial and error in futures trading
is that you don't always take a loss when you trade incorrectly and you don't always make
a profit when you trade correctly. Some of the best methods generate losses more than
half the time. You can take many losses in row applying a very effective system. On the
other hand, if you are lucky, you can make tons of money trading quite stupidly.
Psychologists call this random reinforcement, and it makes good trading impossible to
learn through trial and error.
The most obvious and practical way to learn to trade correctly is to read books. Find the
best books by the most respected authors and the best traders and learn from them. While
this may work in other areas of life, it is more problematic in commodity trading.
Learning to trade is a combination of being exposed to ideas plus practical experience
watching the markets on a day-to-day basis. This is not something that can happen in
only a few weeks. On the other hand, you can become a great trader even with only
average intelligence.
Furthermore, to be successful you don't have to invent some complex approach that only
a nuclear physicist could understand. In fact, successful trading plans tend to be simple.
They follow the general principles of correct trading in a more or less unique way.
Let us now look at few easy to use trading strategies in commodity trading
11
Trading Strategies
Playing with the spreads
In its simplest form, futures spread takes place when you buy one futures contract while
simultaneously sell another, in hopes of making a profit through a favorable difference in
prices during the coming weeks or months. That difference is known as the spread. A
profit can be made between the opposing market positions in two ways:
1) Selling next month futures and buying longer term futures
In this strategy you see that the futures for current month are trading at a lower price than
the futures of the subsequent months for the same commodity. This is normally the case
when the sentiments are bullish for the commodity. Let us look at the example.
Understanding the strategy
As an example, consider the data from the following table:
Date
Expiry
1-Jun-10 05-Aug10
2-Jun-10 05-Aug10
3-Jun-10 05-Aug10
4-Jun-10 05-Aug10
04-Dec1-Jun-10
10
04-Dec2-Jun-10
10
04-Dec3-Jun-10
10
04-Dec4-Jun-10
10
Open High
Low
Close
18434
18815
18434
18716
18760
18850
18610
18637
18621
18621
18390
18450
18760
18760
18260
18728
18574
18918
18841
18525
18920
18940
18750
18765
18686
18690
18536
18554
18508
18875
18421
18851
Now looking at the data from the above table, you observe that the future prices for both
the contracts are falling. However, the closing price for the Dec 2010 contract has been
more than the Aug 2010 futures contract. The spreads between dec and aug futures is
12
increasing. You expect that the spreads are going to widen more for December contract
than the august i.e. December futures prices will grow more than the aug. Hence you
decide to trade in these two contracts of Aug and Dec.
Futures contract specification
Contract terms
Description
Gold June 2010 5th Aug 2010
It’s a gold futures contract
Lot size
1
Contract Size
1 Kg
Price
18730 per 10 gm
Expiry
5th August 2010
Contract terms
Gold Dec 2010 5th Dec 2010
Lot size
Contract Size
Price
Expiry
Description
It’s a gold futures contract
1
10 gm
18845 per 10 gm
5th August 2010
Executing the Strategy
Steps to be performed
1) Call up your broker
Provide your client account number
2) Check available cash balance
You ill need to have enough cash balance
to execute both the contracts (margin
amount could be 5% to 10% of the total
contract size)
Around Rs 3757 (considering 10% margin
on each contract and you entered trade for
13
only 1 contract)
3) Place the sell order for 1 Gold
Aug 2010 futures
4) Simultaneously, place buy order
for 1 Gold Dec 2010 futures
5) Now confirm the orders
Sell gold futures of august expiry at market
price (assuming @ Rs 18730)
Buy gold futures of December expiry at
market price (assuming @ Rs 18845)
Check with the broker instantly if the
orders are placed and executed in the
exchange
Profit/Loss potential
In this strategy, you will sell one futures contract with expiry Aug 2010 @ Rs 18730.
Let’s say If the price of gold Aug futures closes @ Rs 18820 on 5th Aug 2010 (i.e. on the
expiry of the futures contract), you would have made a loss of Rs 70 (18730-18800) per
10 gm (since you had sold the contract, price should have moved downwards to earn a
profit).
On the other hand the futures contract that you had bought i.e. December 2010 futures @
Rs 18845. Suppose the price for December futures is @ Rs 18935 on 5th Aug 2010, you
would make a profit of Rs 90 per 10 gm and the spread increased to Rs 145 (1893518800) from initial spread of Rs 115 (18845-18730). Hence you will earn a net profit of
Rs 20 on these two contracts.
2) Buying next month’s futures and selling long term futures
In this strategy you expect the spread between the two contracts to narrow down in the
near future as you see there is some demand constraint for Silver in coming future. Let us
look at the example.
Understanding the strategy
As an example, consider the data from the following table:
Date
Expiry
Open High
Low
Close
29515
29393
29401
2-Jun-10 05-Jul-10 29457
14
3-Jun-10
4-Jun-10
2-Jun-10
3-Jun-10
4-Jun-10
05-Jul-10
05-Jul-10
05-Sep10
04-Sep10
04-Sep10
29406
29480
29433
29574
29589
29570
29310
29370
29381
29432
29411
29527
29533
29645
29324
29547
29790
29796
29273
29505
Now looking at the data from the above table, you observe that the future prices for both
the contracts are falling. However, the spreads between sep and jul futures is falling. You
expect that the spreads are going to fall further i.e. December futures prices will grow
more than the aug. Hence you decide to trade in these two contracts of jul and sep.
Futures contract specification
Contract terms
Description
Silver Jul 2010 5th jul 2010
It’s a silver futures contract
Lot size
1
Contract Size
30 kgs
Price
29400 per Kg
Expiry
5th July 2010
Contract terms
Silver Sep 2010 4th sep 2010
Lot size
Contract Size
Price
Expiry
Description
It’s a gold futures contract
1
30 Kg
29500
4th September 2010
Remember, the Silver futures price is quoted for per Kg and the minimum contract size is
of 30 Kgs. Hence whatever profit or loss that you earn should be multiplied by 30 to get
profit or loss per contract.
15
Executing the Strategy
Steps to be performed
1) Call up your broker
Provide your client account number
2) Check available cash balance
You ill need to have enough cash balance
to execute both the contracts (margin
amount could be 5% to 10% of the total
contract size)
Around Rs 176500 (considering 10%
margin on each contract and you entered
trade for only 1 contract)
3) Place the buy order for 1 Silver
July 2010 futures
4) Simultaneously, place sell order
for 1 Silver Aug 2010 futures
5) Now confirm the orders
Buy silver futures of july expiry at market
price (assuming @ Rs 29400)
Sell silver futures of September expiry at
market price (assuming @ Rs 29510)
Check with the broker instantly if the
orders are placed and executed in the
exchange
Profit/Loss potential
In this strategy, you will buy one futures contract with expiry Jul 2010 @ Rs 29400. Let’s
say If the price of silver jul futures closes @ Rs 29350 on 5th jul 2010 (i.e. on the expiry
of the futures contract), you would have made a loss of Rs 50 per Kg (29350-29400,
since you had bought the contract, price should have moved upwards to earn a profit).
On the other hand the futures contract that you had sold i.e. September 2010 futures @
Rs 29500. Suppose the price for September futures is @ Rs 29320 on 5th Aug 2010, you
would make a profit of Rs 180 per Kg and the spread decreased to Rs 30 (29350-29320)
from initial spread of Rs 100 (29500-29400). Hence you will earn a profit of Rs 130 per
Kg therefore Rs 130 X 30=Rs 3900 on both these contracts.
16
Trading in a bullish market
Bullish market mean when the sentiments and the general consensus is that the
participants in the commodities market expect the prices to rise in the future. It means the
prices of commodities in the market are rising, with the future prices of the months down
the year are higher than the price of futures contract of current and near the current
month. For example, if the Gold futures for july 2010 is trading at let’s say Rs 18550 and
the futures contract for October, November and December are trading at Rs 18650, 18735
and 18885 respectively, it is said that the market outlook for Gold is bullish. In such a
scenario, we can adopt some trading strategies to make money out of it.
Understanding the strategy: Long on futures
For example: Oil futures. Assume current month to be June 2010
Date
Expiry
Open
High
Low
Close
19-Jul3540
3557
3470
3540
2-Jun10
10
19-Jul3543
3562
3502
3539
3-Jun10
10
19-Jul3558
3596
3468
3481
4-Jun10
10
3600
3655
3585
3608
2-Jun- 19-Sep10
10
3641
3665
3613
3647
3-Jun- 19-Sep10
10
3665
3692
3593
3612
4-Jun- 19-Sep10
10
In the above table it is evident that the oil futures price for the sep expiry are trading
higher than the july prices. You expect that the oil price will go up in the near future (at
least for next 2 months). So you decide to play this strategy. Hence you buy july futures
@ market price of let’s say Rs 3600 per barrel.
17
Futures contract specifications
Contract terms
Crude Oil Jul 2010 19th jul 2010
Lot size
Contract Size
Price
Expiry
Description
It’s a crude oil futures contract
1
100 bbl
3600 per Kg
19th July 2010
Remember the crude oil price is quoted per barrel and the minimum contract size is of
100 barrels. Hence with the above contract your total contract value would be of Rs
360000.
Executing the Strategy
Steps to be performed
1) Call up your broker
Provide your client account number
2) Check available cash balance
You ill need to have enough cash balance
to execute both the contracts (margin
amount could be 15% to 20% of the total
contract size)
Around Rs 72000 (considering 20% margin
on each contract and you entered trade for
only 1 contract)
3) Place the buy order for 1 Crude
oil July 2010 futures
4) Place a stop loss for your contract
Buy crude oil futures of july expiry at
market price (assuming @ Rs 3600 per bbl)
Add a sensible stop loss for the contract
which is maximum loss tolerable by you
and is within the normal volatility of the
crude futures (say Rs3490).
5) Now confirm the orders
Check with the broker instantly if the
orders are placed and executed in the
exchange
18
Profit/loss potential
Now in this above strategy, you will make money if the price for the july crude futures
move up according to your expectations. The maximum loss that you will incur is Rs 110
per barrel (your stop loss). Let’s say the crude price moved up to Rs 3785/bbl on 5th of
July 2010. You decide to exit the futures contract by selling the contract. Thus you will
make a profit of Rs 185 per bbl (3785-3600). Thus your net profit would be 185 X
100=Rs 18500 per contract. So you made 25.69% (18500/72000 X 100) in 1 month.
Trading in a bearish Market
Bearish market means when the sentiments and the general consensus of the participants
in the commodities market expect the prices to fall in the future. It means the prices of
commodities in the market are falling, with the future prices of the months down the year
are lower than the price of futures contract of current and near the current month or the
prices have a constant and lower spread. For example, if the Copper futures for july 2010
is trading at let’s say Rs 350 and the futures contract for October, November and
December are trading at Rs 351, 352 and 353 respectively, it is said that the market
outlook for Copper is bearish. In such a scenario, we can adopt some trading strategies to
make money out of it.
Futures contract specifications
Contract terms
Copper Apr 2010
Lot size
Contract Size
Price
Expiry
Description
It’s a copper futures contract
1
1000 Kg
343 per Kg
30th April 2010
Remember copper price is quoted per Kg and the minimum contract size is of 1000 Kgs.
Hence with the above contract your total contract value would be of Rs 343000.
19
Understanding the strategy: Short on futures
For example: Copper futures. Assume current month to be March 2010
You have found out that there is going to be low copper demand in the coming future,
which will create lot of stockpiles resulting in fall in price.
Date
3/1/2010
3/2/2010
3/3/2010
3/4/2010
3/5/2010
3/1/2010
3/2/2010
3/3/2010
3/4/2010
3/5/2010
Commodity
Copper
Copper
Copper
Copper
Copper
Copper
Copper
Copper
Copper
Copper
Expiry
Open
High
Low
Close
4/30/2010
334.5
344.7
334.5
339.2
4/30/2010
338.15
345.25
335.1
344.75
4/30/2010
344
349.45
340.1
345.7
4/30/2010
345.1
347
339
341.05
4/30/2010
341.5
347.35
340.5
343.45
6/30/2010
338.5
346.45
338.5
340.95
6/30/2010
339
346.9
336.75
346.4
6/30/2010
344
351.1
342
347.35
6/30/2010
344.1
349
340.8
342.8
6/30/2010
343.35
348.95
342.2
345.1
Under this strategy you will sell Copper April futures let’s say @ Rs 343. Remember it is
always risky to deal in futures of longer term period as the market conditions might
change in 3 months down the time. Hence you should short the nearest available futures
to the current month. At the expiry of April futures i.e. on 30th April, the situation looked
like this:
Date
Commodity
4/30/2010 Copper
Expiry
Open
High
Low
Close
4/30/2010
328
330.2
325.4
327.75
The futures contract at expiry closed at a price of Rs 327.75 and hence you made a profit.
Executing the Strategy
Steps to be performed
1) Call up your broker
Provide your client account number
2) Check available cash balance
You ill need to have enough cash balance
to execute both the contracts (margin
amount could be 15% to 20% of the total
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contract size)
Around Rs 68600 (considering 20% margin
on each contract and you entered trade for
only 1 contract)
3) Place the buy order for 1 Crude
oil July 2010 futures
4) Place a stop loss for your contract
Buy copper futures of April expiry at
market price (assuming @ Rs 343 per Kg)
Add a sensible stop loss for the contract
which is maximum loss tolerable by you
and is within the normal volatility of the
crude futures (say Rs353).
5) Now confirm the orders
Check with the broker instantly if the
orders are placed and executed in the
exchange
Profit/Loss potential
Now in the above strategy, you will incur a maximum loss of Rs 10 (343-353) per Kg,
limited to your stop loss price. The loss per contract comes to Rs 10000 (10*1000). How
ever, in this strategy you made a profit by holding on to the futures till the expiry date.
Your profit comes to Rs 15.25 (343-327.75). Hence your profit per contract is Rs 15250.
Thus you made 22.23% on your investment of Rs 68600 in less than 2 months.
Trading in a Range bound market
Range bound markets are those where the volatility is high and there is no clear direction
of the movement in the prices of the commodities.
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If you look at the above graph, the gold price has hovered between 18430 to 18560 for the past
10 trading sessions. In such a scenario you could have made money in three different ways:
1) Short futures: In this strategy, you should first sell the futures at the prevailing price. As
you could see in the above diagram, you should have sold futures on 1st trading session
@ Rs 18550. On the 2nd trading session, you could have bought back the same futures
contract @ Rs 18430, by squaring off or offsetting your short position. Thus you could
have made Rs 120 per 10 gm. Your ROI comes to 6.46% on investment of Rs 1855 in 1
day!
2) Long Futures: In this strategy, first buy futures at the current price of say Rs 18440 on
5th trading session. You should take 1 or 2 trading session break to see the performance
of the gold price movement to check if there is any trend or direction. Then on the next
day on 6th trading session, you should sell your futures at the current price of say Rs
18550 to cover your long position of the 5th trading session. Hence in this strategy you
will make a profit of Rs 110 per contract.
3) Follow the trend: In this strategy, you should be able to track the trend in the price
movement of the commodity. Once the trend is spotted, you should enter the
appropriate trading strategy. In the above graph, you could see a trend in the behavior
of the price movement. It first felt on 2nd trading session, then rose in the 4th session
then again fell in the 5th session and then rose in 6th session. So there is some trend in
the movement of price. You can capitalize on such trend. Hence you should buy futures
on the 8th trading session, as the price should rise according to the observed trend.
Hence you buy futures on 8th day for say Rs 18455. On the next day, on 9th session you
sell your futures for Rs 18550, thus making a profit of Rs 95 per contract.
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Thus by adopting these three strategies in the range bound market you could have made Rs 325
in 9 trading sessions.
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HEDGING STRATEGIES USING FUTURES
Hedging actually means minimizing the risk involved in trading. It is an attempt to offset
the open position in trade. It helps the trader or investor in protecting himself from
adverse effects of an unexpected event.
It is a kind of insurance for your trading position. Hedging can be done by using futures
contract. There can be two possible ways of hedging one’s exposure in commodities
market. First, cash market position hedging with futures and second futures position
hedging with futures contract.
Cash market hedging
Hedging in the futures market is a two-step process. Depending upon the hedger's cash
market situation also known as spot market, he will either buy or sell futures as his first
position. For instance, if he is going to buy a commodity in the cash market at a later
time, his first step is to buy futures contracts. Or if he is going to sell cash commodity at a
later time, his first step in the hedging process is to sell futures contracts.
The second step in the process occurs when the cash market transaction takes place. At
this time the futures position is no longer needed for price protection and should therefore
be offset (closed out). If the hedger was initially long (long hedge), he would offset his
position by selling the contract back. If he was initially short (short hedge), he would buy
back the futures contract. Both the opening and closing positions must be for the same
commodity, number of contracts, and delivery month.
For Example
Assume you are a dealer in copper and you have got order of 100 Kgs of copper to sell
only by July. You have inventory of 100 Kgs of copper at Rs 310. By hedging, you can
lock in a price for your copper in June and protect yourself against the possibility of
falling prices.
At the time, the cash price for copper is Rs310/Kg and the price of August copper futures
is Rs 325/Kg.
You can short hedge your copper by selling 100 copper 1 Kg August futures contracts at
Rs 325.
By the beginning of July, cash and futures prices have fallen. In July, you sell 100 Kg of
copper from the market at Rs 295/Kg to fulfill your order to the customer. Here you made
a loss of Rs 15/Kg.
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June
Cash
Futures
Price for
Sell 100 August
Copper at Rs 295/Kg
Copper futures
at Rs 325/Kg
July
Sell 100 Kgs of
Buys 100 August
Copper from the market Futures contract
For Rs 295/Kg
Result
Rs 300/Kg
Cash sale price Rs 295
Futures gain – 15/Kg
Net Gain 25-15=10
Had you not hedged, he only would have received Rs 295/Kg for your copper- Rs 15/Kg
lower than the cost price of the copper.
The risk of loss exists in commodity futures trading. Past performance is not necessarily
indicative of future results
Futures Market: This is more prevalent form of hedging exercised. In this form, you
either have an open position in futures, which you offset by entering into exactly opposite
side of the transaction to cover your earlier position in such a manner that minimizes loss.
For Example:
When there is no direction in the price of gold
During the intra day trading session, when you see that there is not specific direction or
trend in the movement of price, you’ll have to improvise a different trading strategy.
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Like in the case of above chart, it is gold futures expiring on 5th aug 2010. It is clear from
the graph, that the gold price behavior has no specific direction in it and it’s volatile. As a
trader, it becomes really difficult to make money in such a market condition. Then what
can be done in such a scenario? You should use a strategy called straddle. It means you
should buy and sell the futures contract at the same price having a stop loss on both the
contracts. It is always advisable to wait and observe for any patterns or direction if you
are able to spot in the price movement. Let’s say after some observations, you decide to
trade in the futures contract at about 11:30 AM. You use the strangle strategy where you
bought and sold gold futures at the same price of Rs 18535 keeping a stop loss of Rs
18525 on long contract (basically assuming that the price have bottomed out and there is
not much room for price to fall further) and Rs 18550. Now using this strategy will hedge
your position and minimize your losses. When the price moves up, you will make money
on the long (the one that you bought) futures contract and at the same time you will lose
the same amount on the short futures contract. Hence your position is hedged.
Now let us calculate how much profit/loss you have mad at different point in time. At 12
noon, when the price is at Rs18540, you made Rs 5 (18540-18535) on the long contract
and lost Rs 5 (18535-18540) on the short contract. Both the contracts are still valid as
none of them have actually triggered their respective stop losses. Now at 12:30, the gold
is trading at Rs 18558. Now here your short futures contract got executed at the stop loss
price of Rs 18550 which means you made a loss of Rs 15 on the short contract. On the
other hand you have a profit of Rs 23 (18558-18535) on the long contract. Hence you
made a net profit of Rs 8. Once one of your contracts gets its stop loss triggered, it means
the price movement has found itself a direction and you can hang-on to another contract
for a while. In this case it requires you revise your stop loss slightly on the upside from
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Rs 18525 to Rs 18535 as the price has move up in the direction. If you observe, the price
again came down and reached Rs 18538 levels at about 12:45. And then it shoot up Rs
15575 about 1 pm. This is the time you get out of the contract as you have made a profit
of Rs 50 (18575-18535) on a single contract which seems to be a big fluctuation in
today’s trade ( Today’s high is Rs 18580 and low of Rs 18525 which is like a difference
of 55). Hence by exceeding at Rs 15575 you have made a net profit of Rs 35 (50-15).
The key to make money in this strategy is the stop loss. You have to be really smart at
calculating the appropriate stop loss for your contracts and revising the stop losses
according to changing conditions.
Risk in this strategy – The only risk the trader faces in this kind of strategy is that he
will make loss if one of the contracts gets executed due to triggering of stop loss and the
other one obviously is till on. In such case you could either hang on to the other contract
for few more price fluctuations and then exit out of it or if you are a risk taker, then you
can either continue holding your active contract like In the case above or can even enter
into another contract (go short if you are long on the other contract) at the current price.
That’s how you can minimize your risk. Or at the end of day if none of your contracts
trigger their respective stop loss limit, you will end up making no money as your position
will be perfectly covered and hence no profit no loss for you.
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