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Commodities are perfect portfolio enhancers and diversifiers, and many global investors use commodities for portfolio returns enhancement and diversification amid negative to no correlation of commodities with traditional assets such as equities and bonds.
Why trade in Commodities?
Firstly, unlike many financial assets, commodities prices are not directly determined by the discounted value of future cash flows, and commodity prices are not as directly related to change in forecasted cash flows and changes in market discount rates. Instead, commodity prices are evaluated primarily on forecasts of the commodity’s supply and demand.
The commodity prices hold negative to low correlation to certain traditional asset classes as they are driven by different economic fundamentals as compared to stocks and bonds, which further gives a portfolio diversification advantage.
Secondly, the exposure to commodity provides an investor with a hedge against the inflation risk, i.e. decrease in the purchasing power of the money.
Nominal commodity prices are generally highly correlated with inflation as commodity forms a part of the definition and computation of inflation, and physical commodities such as oil are an important component of the computation of inflation; thus, the nominal prices of commodities and other real assets would move in tandem with inflation.
However, the nominal and real prices (nominal adjusted for inflation) of stocks and especially bonds tend to be negatively correlated with inflation because inflation raises the discount rates applied to their valuations.
Thirdly, there are certain commodities that remain immune to the business cycle as compared to traditional assets, which may react very differently. The value of stocks and bonds is derived from expectations regarding long-term earnings or coupon payments of the concerned domestic economy; however, commodities prices are driven by global factors.
To know how commodity prices, link with inflation and other technical terms and their correlation with each other, Do Read: Is P/E Ratio A Good Valuation Metric To Value A Resource Stock?
Like any good trading decision, it is prudent to enter a trade at the low and exit at high prices, the same holds true for commodity trading as well. It becomes imperative to have a good checklist before plunging into commodity trading.
Do’s and Don’ts of Commodity Investing/ Trading
Do’s
- Follow Money Management Trading Strategies
- Find your optimum portfolio allocation
Commodities are mainly used to enhance return and diversify risk. An investor should always look for an optimized portfolio allocation, as overexposure in commodities could disrupt the return profile of the portfolio amid higher volatility in alternative assets as compared to traditional assets.
While, the optimum allocation purely based on an individual capacity to tweak the risk and reward profile, there are some basic allocation models such as Kelly Criterion, which could assist investors in identifying their optimum allocation.
The Kelly percentage of allocation could be calculated as below:
Where K % = Kelly percentage
W = winning probability
R = win/ loss Ratio
Interpretation- A ratio of 10 percent (K % = 10) would suggest allocating 10 percent of the total capital to a particular asset in the portfolio.
- Find trades with a decent risk-to-reward ratio
This is one of the crucial steps before taking on any trade in the market, and traders should first define the potential reward of putting in their money into a trade as compared to the loss. Ideally, a risk-to-reward of minimum 1:2 is followed; however, investors should always consider the probability of the achievement, i.e., the probability of achieving a target before the stop-loss is hit. If the probability of hitting a reward is relatively lower than the probability of hitting the stop-loss, an ideal trader might expect a higher risk-to-reward ratio, and it could be justified.
- Define stop loss before entering into any trade and stick to it
Stop loss could be defined as the maximum loss a trader can absorb per trade, which should be strictly followed and adjusted as less as possible post entering the trade.
- Follow the trend and trail your stop loss
We have heard quite often that “trend is a friend” and following this simple yet effective measure could potentially provide long-term benefits.
Don’ts
- Over leverage
Commodity trading is mainly done through future contracts, where the leverage provided by a broker is much larger than any other asset class. Leverage could increase the magnitude of both profit and loss; thus, investors should be familiar with the type and amount of leverage they are utilizing per trade.
- Don’t average if security trades against you
This is one of the many large observation, which is common among traders and should be avoided by an astute trader and professionals. While averaging up when the trade is moving in favor could provide benefit, the hopeful averaging, when a trade is moving against you, could blow out your account.
- Avoid recency bias and follow the trend
It is quite evident that the latest development and events do hamper the psychology of a trader, which leads to a psychological trap known as recency bias. Recency bias could be defined as the phenomenon where a trader tends to higher weightage to recent events and ignore base rate.
For example, a fall in demand for copper could bring the price of the commodity down; however, a long holder might see a dead cat bounce and ignore the fundamental factors that influence copper demand, which could potentially blow out the account of a trader.
The London Metal Exchange is one of the world’s largest commodity exchange. Commodity as an asset class is highly liquid and provides traders abundant opportunities to choose from. Trading is both an art and science, thus every trader has to develop a trading framework that suits the trader’s personality. Like every other business, traders need to approach trading with a well-formulated plan.
