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Successful Commodity Trading Strategies in India

06 May 2022 0 COMMENT

In the commodity derivatives market, there are two types of trading strategies namely directional and non-directional. In directional trading, traders take regular buying and selling based on market movement and prediction. In non-directional trading strategies, the buying and selling are done simultaneously irrespective of market direction. Non-directional trading strategies carry low risks as the positions are locked to each other. In case of unfavourable market movement, the losses in one position are compensated by profits in other position. Let us see the different trading strategies we can formulate in the commodity derivatives market.

Before understanding in detail about trading strategies, it is important to understand two market conditions i.e., Contango and Backwardation. Contango is a market situation where the far month contract is trading at higher price compared to current month contract while Backwardation means far month contract is trading lower compared to current month. These two conditions are very important while generating non-directional trading strategies.

Top Successful Commodity Trading Strategies

I. Spreads

Spreads are strategies used by traders to profit from discrepancies in market price movements by taking a long and short position simultaneously in a single commodity or between two different but correlated commodities. 

  A.  Calendar or Intra commodity spreads

This is the most common spread strategy used by today’s traders. This spread is executed by a trader or investor by taking long and short positions in two future contracts with different maturities but within the same commodity. Calendar spreads are further divided into two types viz., bull spread, and bear spread. Bull spread means buying far month contract and selling current month contract and bear spread is reverse of bull spread.

Bull Spread: Bull spread is initiated when the current month contract is overvalued and next month contract is undervalued. For example, if trader expect the spread between March - April MCX Nickel futures price will increase in futures, then the trader can capitalize the price movement by executing the following strategy.

25 Feb 2022

Forecast

Contract

Price (Rs. /Kg)

Contract

Price (Rs. /Kg)

March 2022

1854

March 2022

1865

April 2022

1847

April 2022

1870

In this example, April month Nickel futures are trading at a discount to March contract and trader expects that the difference between March and April contract would become positive. Hence, trader sells March contract and buys April contract. The profit realization from this strategy when spread rises is presented below. 

 

March 2022

April 2022

Change (Apr-Mar)

25 Feb 2022

Sells @ 1854

Buys @ 1847

7

10 Mar 2022

Buys @ 1865

Sells @ 1870

5

 

-11

23

 

Net Profit Realized

12

12

Bear Spread: Bear spread trading happens when the current month contract undervalued and next month contract is overvalued. In this situation, trader buys the current month contract and sells far month contract in anticipation of reduction in the spread. In the following example, MCX cotton for March expiry is undervalued and April contract is overvalued, hence, the trader is buying March contract and selling April contract as follows.

25 Feb 2022

Forecast

Contract

Price (Rs. /Bale)

Contract

Price (Rs. /Bale)

March 2022

37100

March 2022

37300

April 2022

37400

April 2022

37500

The profit realization from this strategy when spread rises is presented below. 

 

March 2022

April 2022

Change (Apr-Mar)

25 Feb 2022

Buys @ 37100

Sells @ 37400

300

10 Mar 2022

Sells @ 37300

Buy @ 37500

-200

 

200

-100

 

Net Profit Realized

100

100


Additional Read: How to trade in commodity?

 B.   Inter Commodity Spread: This strategy involves taking long and short position in futures contract in different but correlated commodities. The trading contract can be same or different for both the commodities. Some of examples of inter commodity spread are Lead and Zinc, Aluminium and Zinc, Aluminium and Lead, etc. 

Example: If the trader expects the spread between Lead and Zinc futures rise then the trader can capitalize the price movement by executing the following strategy. 

25 Feb 2022

Forecast

Contract

Price (Rs. /Kg)

Contract

Price (Rs. /Kg)

Lead 

187

Lead

190

Zinc

300

Zinc

310

Lead and Zinc carry a strong correlation because both are extracted from the same mine. The profit realization from executing inter commodity spread between Lead and Zinc is presented below. 

 

Lead

Zinc

Change (Apr-Mar)

25 Feb 2022

Sell at 187

Buy at 300

-113

10 Mar 2022

Buy at 190

Sell at 310

120

 

-3

10

 

Net Profit Realized

7

7

II. Trading strategies using commodity indices

Commodity indices are blessing in disguise for the newcomers in the commodity derivatives market. These are cash settled contracts and size of the contract is smaller compared to futures contracts of underlying commodities. Indices capture the collective price action of underling constituent and several trading strategies can be designed using index and futures contract of its constituents. In India, three sectoral indices are allowed for trading on MCX and these are BULLDEX, METLDEX and ENRGDEX. 

The most popular trading strategies we can create are between METLDEX and futures contracts of individual metals. If you are having a long in METLDEX and you are carrying negative view in one or two metal say Lead and Zinc, then short position in Lead and Zinc could  be created against the buy position in METLDEX. 

III. Options Trading Strategies

Irrespective of market movement whether it is bullish or bearish or neutral market movement, you can create  multiple  trading strategies using  options. Some of the popular option trading strategies are:

  • Call Buy & Call Sell
  • Put Buy & Put Sell
  • Covered Call Option
  • Covered Put Option
  • Straddles and Strangles

  1.  Call Buy and Call Sell: When a trader expects that the price of an option may rise  then the trader could buy and sell call options at different strike prices and vice versa.. When a  traders buys a call option, then the trader would l pay the premium and when a trader sells a  call option, then margin amount is paid..

  2.  Put Buy and Put Sell: a Put buy options given the buyer a right but not the obligation to sell the option upon expiry. When a  trader expects that the price of an underlying may fall , the trader  could buy and sell put options at different strike prices and vice versa..

  3.   Covered Short Call: Combining a long underlying position with a short call option results in a covered short call position. In a stagnating market, a covered call option aims to increase return while also partially hedging a long underlying position. 

Assume you have a crude oil purchase position of Rs.8200 per barrel. For a premium of Rs 360, you write a single call option with a strike price of Rs 8300. On the day of expiry, following scenario occur

  • If the price stays at Rs.8200 and the option is not exercised, then you will retain the Rs.360 premium.
  • If the price of crude oil climbs to Rs.8300, you keep the Rs.360 premium (on options) plus a Rs.100 per barrel gain (on the spot position)
  • If the crude oil price falls to Rs.8100, the buyer does not exercise the option, and the seller keeps the premium of Rs 360.

  4.  Covered Short Put:A covered short put position is a hedging strategy in which a trader  sells a put option and receives premium and at the same time holds aa long position in an underlying.... A covered short put trade aims to increase the return on investment and hedging at the same time.

Assume you enter a covered short put position on gold, selling a Rs 50,500 put for a premium of Rs.600 at a current price of Rs.50,000. Upon expiry, the following scenarios occur.

  • If the price remains unchanged, put option would not be  exercised , and the premium of Rs. 600 received would  constitute the  profit.
  • The option would be  exercised if the price falls to Rs 49,900,. In such a case the loss would be  mitigated by the premium received.. In this situation, your loss on the option position due to the price reduction is 50500-49900=600, and would be  offset by the premium of Rs 600 received , resulting in a net loss of zero.
  • If the price climbs to Rs 50600 or higher, the buyer will not exercise the option, and you  would make a profit of Rs 600.

  5.  Straddles and Strangles: One of the most common option trading methods is to buy calls and puts at the same time to profit from a change in the underlying commodity's volatility. Long position in options is taken when  an increase in volatility is expected and short position in options when it’s expected that volatility would be normal and price movement would be range bound.. 

Long Straddle: A long straddle is an option strategy in which a trader pays premium to buy a call and a put with the same strike price and expiry date.

Long Strangle: Buying a call and a put with the same expiration date but different strike prices is known as a long strangle.

Additional Read: How MFs Add Value to Commodity Trading?

Summary

As a commodity market participant, one can do directional and non-directional trading. Under a directional trading, it is just  buying and selling commodity derivatives based on market movement and expectations.. In non-directional trading, various trading strategies such as bull spread, bear spread, inter commodity spreads,   strategies using index, futures and options could be  generated. These trading strategies are low risk strategies as the buying and selling are  done instantaneously with the reduction of risk on adverse price movement.. Further, margin requirement in spread strategies may also get reduced and often offered by a broker member to its customers...

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