How should investors approach commodity futures trading? In her August 2016 paper entitled “An Introduction to U.S. Commodity Futures Markets: a Historical Perspective Along with Commodity Trading Principles”, Hilary Till summarizes success factors for designing and managing a commodity futures portfolio, including: identifying potential trades; constructing trades; constructing a portfolio of trades; risk management; payoff expectations; level of leverage; and, interaction of the commodity futures portfolio with holdings of other asset classes. Based on her experience and empirical examples, she concludes that:
- Over the long term, profitable commodity trades are most consistently available in energy, base metal and livestock commodities, likely due to:
- Difficulties/costs of storage and associated small inventories relative to demand.
- Consequently volatile spot prices, driving producers to hedge forward price risks.
- Associated commercial hedging pressure driving futures prices below expected spot prices, such that long commodity futures positions have positive expected returns.
- Commercial traders (producers) willingness to pay premiums for futures is predictably seasonal for some commodities (agricultural and energy)
- Commodity futures trading programs generally offer a long options-like payoff profile, with magnitudes attractive only with leverage (because edges are small).
- Trades within a futures portfolio should be mutually diversifying (have low return correlations). A key concern is inadvertent concentration due to usually unrelated commodities temporarily exhibiting high correlation (such as natural gas and corn during July due to joint weather dependence). Avoiding inadvertent concentration requires an economic understanding of trades.
- Risk management seeks to ensure that trade and portfolio losses do not exceed specified thresholds during both normal times and extreme events. Useful risk measures include:
- Trade and commodity portfolio value-at-risk based on recent volatilities and correlations.
- Trade and commodity portfolio worst losses during normal times and during extreme events.
- Trade contributions to portfolio value-at-risk and worst loss during extreme events.
- Effective exploitation of opportunities involves:
- Good trade entry rules (futures series in backwardation, favorably anomalous price, favorable seasonality).
- Good trade exit rules (price target, time stop, worst-case loss).
- Judicious trade construction (direct contracts, calendar spreads, intermarket spreads, options).
- Monitoring of fundamental drivers (such as low commodity inventories).
- Investors should also determine how well a commodity futures portfolio diversifies other asset class holdings.
In summary, evidence indicates that: (1) favorable conditions persist for some commodity futures trading due to producer hedging needs; and, (2) traders can successfully exploit such conditions based on an understanding of underlying economics and disciplined trading.
Cautions regarding conclusions include:
- Many investors can access the required level of commodity expertise/monitoring only via funds, thereby bearing fees that lower returns.
- Relatively recent financialization (availability of commodity-based exchange-traded products) may alter commodity futures price behaviors.
