Market functions like fire. A trader should be properly equipped with modern tools before entering into market arena. In all probabilities, a trader not possessing proper skill set to play with the fire will burn his fingers. The market will throw him out of the arena, after squeezing him mercilessly.
On the other hand, if a trader sharpens his skill-sets to fight the battle, he can tame the fire and use it to his advantage. Trading with proper strategies, not only results into wealth creation for the trader, but also helps the market to grow on sustained basis.
In absence of successful trading skills, there is widespread value erosion for most of the participants, which results into more number of people deserting the market after operating for few months, which damages the market sustenance in the long run.
Hence, in order to ensure their own long term survival, the markets are duty-bound to impart knowledge among participants, caution them against possible pitfalls and help them mature in their trading skills.
Such requirement is particularly more significant in case of Commodity Exchanges, which have come into existence recently and have attracted millions of traders and investors, who are already participating in the market.
However, in order to sustain the pace of growth in the years to come, it is important to introspect the nature of trades usually done by the traders, to identify deficiencies in such strategies leading to loss of capital and to suggest possible solutions to such matters.
On a survey of some small traders in commodity exchanges, it is interesting to note that, still, many of the traders/speculators do not analyze the volatility factor of a commodity first, so as to plan their trading strategies based on such volatility.
Each underlying commodity has a different type of volatility. Volatility can be defined as the range within which the price of a commodity generally moves during a given period of time.
When we say average volatility, we should not consider the extreme volatility exhibited by different commodities at certain points of time due to certain special events. The difference in volatility in different commodities is a function of:
- Historical price behavior.
- Liquidity of the commodity - volatility tends to be lower if a commodity is high liquid and impact cost of putting in a position is lower while it would be higher if the liquidity is low.
- The number and nature of various participants in the commodity - usually volatility in the price of a commodity is lower if large number of people participate in trading and also the participants are from different backgrounds participating in the trading of a commodity for different objectives.
For instance, if trading in an instrument consists of large number of speculators only, it would be more volatile. But, if it consists of sizeable participation from investors, jobbers, arbitrageurs, hedgers, physical market traders, short term and long term position traders, etc., it will be less volatile.
It is very important for a trader to understand this aspect while determining the size of the position which he should put in. The common mistake many traders do is to determine the position size based on the margin requirement of the Commodity Exchange.
However two different commodities, though, may attract same margin, the risk involved may not be same vis-à-vis the same position value. Though many a time, a trader is right in taking directional call on a commodity price, still, due to inappropriate position sizing, either he is not able to realize the potential of the call he made or he gets stopped out due to lack of understanding of inherent volatility of the underlying commodity.
Therefore, it becomes very important that a trader understand the inherent volatility of each commodity and accordingly determines the position size.
A trader should
Take smaller positions in those commodities which have got higher volatility so that he can allow the commodity price to oscillate over a larger span of price movement so that he does not get stopped out. Examples commodities with higher volatilities are - copper, zinc, potatoes and certain other agri commodities.
Take bigger bets in those commodities which have got lower volatility so that he can take advantage of smaller movements and lock-in the profits. Example - gold, silver and crude oil.
For example if a traders wants to take a position worth Rs 50 lacs (Rs 5 million) in commodities. He can take position in 5 lots gold of 1 kg each or 20 lots of copper of 1 metric ton.
The risks for the trader in these positions are totally different. Due to higher inherent volatility of copper prices, the trader is exposed to a higher risk in Copper than Gold. This is because the percentage movement in the price of copper on daily basis is multiple times higher than gold.
Hence, if he takes a position of Rs 50 lacs in copper, after paying a margin of 7 per cent, that is, Rs 350,000, there is all likelihood that he may suffer more than 50 per cent of his capital of Rs 350,000 due to sudden movement of 3-4 per cent in case of price of copper.
Hence, if a trader has a capital of Rs 350,000, it is advisable to take position of only Rs 10 lacs (Rs 1 million) in copper contact, pay a margin of Rs 70,000 and set aside the rest amount of Rs 280,000 for meeting the MTM calls. If the sizing of his positions in futures is designed in such manner, he will have a better chance to get positive returns on his investment.
The problem originates when an investor with Rs 350,000 capital approaches a broker and asks him how much position he can take. The broker looks at the Exchange margin requirement and if the margin percentage rather than inherent volatility of each commodity. The broker does not advise him based on underlying volatility that equal position value in copper and gold are actually not equal in terms of their inherent risks.
Therefore, in order to maximize returns, a trader should analyze volatility of the respective commodity in which he wants to take a call, and then decide his position sizing.
Higher the volatility, lower should be the size of his position, even if it means investing only a part of his capital towards margin.
Anjani Sinha is Director, Multi Commodity Exchange of India Limited, Mumbai. The views expressed above are personal.
