Job of a commodity specialist

[BREND]

When I was a commodities specialist in a bank, a lot of my friends thought that most of my customers had bought commodities to tap on the commodity supercycle.

Actually that is not true; more than 70% of the customers then were hedgers and only 30% were speculators.

This is the same reason why our commodity desk was very profitable then.

Why?

If the customer is a speculator, most likely he is trading 1 - 5 lots of copper. The customer knows that trading futures is risky, so he is trading within his means. While for a corporate in a manufacturing or physical trading business, the customer will be trading 40 - 100 lots of copper to hedge his physical positions.

In addition, since futures trading is a speculative activity, over time the losers will be gone and only the winners stay. So this speculative group of customers will become smaller over time. But in hedging, the same customers will come again, because as long as their business is running, they will need to hedge for risk management purposes. As good words spread of this team, most hedgers will come in.

The knowledge of hedging and risk management was very crucial in my job then. Here is a common senario from a corporate customer (hedger):

The customer called me and told me that:

He had bought 2000 metric tons of copper from his supplier based on September average price, delivery in early October.

At the same time, he had already sold 500 metric tons at $7300 to a customer, delivery in mid October. If price rises higher in mid October, he does not want to miss the opportunity on the price appreciation.

He asked me what should he do to hedge his risk.

i) Current price of copper was trading $7000
ii) September average price is unknown, we will only know the price at the close of September trading day (30th September).
iii) Contract size for 1 lot of LME Copper is 25 metric tons of copper (LME represents London Metal Exchange)

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My answer to my customer would be:

a) Since he had bought 2000 mt of copper from his supplier based on September average price, he should short the same amount of contract size in the futures market based on September average price. This would mean short 2000 / 25 = 80 lots of copper futures.

By 1 October, the customer will have a short position on 80 lots of copper futures at September average price. At the same time the customer had fixed the cost of his physical copper at September average price. So this physical trade is hedged.


b) The customer also mentioned that he had sold 500 metric tons at $7300 to a customer. To hedge his risk, he should buy copper futures at market rate based on the same contract size, which is 500 / 25 = 20 lots of copper futures.

In the event that copper price raises to $7700 by mid October which is the delivery date, he should have profited 7700 - 7000 = 700 x 25 = US$17,500 from the futures market.

At the same time he lost the opportunity to sell his phyical good at higher price of 7700, opportunity loss is 7700 - 7300 = 400 x 25 = US$10,000. So this physical trade is hedged as well.


Rising commodities price can reduce profit margin of your business. Hedging is a strategy designed to minimize exposure to an unwanted business risk.

 

[jamescummins]

Sorry to be argumentative, but my metals experience is very different..

I know that on the LME the biggest member by volume traded made more money from speculators, and the majority of our business was speculators. Also, a desk is profitable either because they run risk that earns them money, or (predominantly in my experience) they are capturing the spread by market making, and taking commissions. Also with metals, the ring dealers are making money because they are essentially a monopoly and everyone has to trade through them on the floor. Commissions for fun to be had

The next thing was average pricing for example. You cant just trade the sep average, you have to trade daily to build that average. That requires trading at settlement which is hard to capture, and monitoring positions. If you only had a five lot exposure, you couldnt directly trade the average. Granted, you can trade tapo's, but not directly the futures.

 

[BREND]

Sorry to be argumentative, but my metals experience is very different..

I know that on the LME the biggest member by volume traded made more money from speculators, and the majority of our business was speculators. Also, a desk is profitable either because they run risk that earns them money, or (predominantly in my experience) they are capturing the spread by market making, and taking commissions. Also with metals, the ring dealers are making money because they are essentially a monopoly and everyone has to trade through them on the floor. Commissions for fun to be had

The next thing was average pricing for example. You cant just trade the sep average, you have to trade daily to build that average. That requires trading at settlement which is hard to capture, and monitoring positions. If you only had a five lot exposure, you couldnt directly trade the average. Granted, you can trade tapo's, but not directly the futures.

No worries, we can take it as a discussion.

We do not take spread from customers, we only charge commission, this is why our customers like to deal with us. We are not allow to run risk according to bank's regulation.

Yes we certainly can trade average for 5 lots, we had done it so many times. If you cant maybe you can refer me to those customers who need to trade 5 lots or less.

By the way I am no longer working as LME broker, I am now working as investment manager in a hedge fund trading other markets.

 

[jamescummins]

Hi - cool, discussions are good and arguments are bad

What I meant with regards to average pricing is that if you want to trade 5 lots of the september average price, you have to trade a percentage of your commitment for each deliverable day in september. So, say there are 20 good delivery days, you would need to trade 5/20 lots every day - i.e.0.25 of a lot, which you cant do. Also, to trade the average of sep, you need to trade at the settlement price everyday. I know as a broker you can offer to do this, my point is that it is only doable by a firm that has enough size on client orders to have a large average book. If I was your only client say, then your bank could not provide me the sep average without running risk yourselves. Also, if you dont trade on the floor, the average is going to be hard to match to the sett. prices. Even when you are on the floor it is tricky!!!

 

[BREND]

Hi - cool, discussions are good and arguments are bad

What I meant with regards to average pricing is that if you want to trade 5 lots of the september average price, you have to trade a percentage of your commitment for each deliverable day in september. So, say there are 20 good delivery days, you would need to trade 5/20 lots every day - i.e.0.25 of a lot, which you cant do. Also, to trade the average of sep, you need to trade at the settlement price everyday. I know as a broker you can offer to do this, my point is that it is only doable by a firm that has enough size on client orders to have a large average book. If I was your only client say, then your bank could not provide me the sep average without running risk yourselves. Also, if you dont trade on the floor, the average is going to be hard to match to the sett. prices. Even when you are on the floor it is tricky!!!

Thanks, I already said we can do it. We give what the customers want, and we do our part, end of the day we get commission, I dont see any issue.

Do recommend those smaller customers to me if you dont want them, I can refer them to my friends who are still working for LME products.

 

[jamescummins]

I am obviously rubbish at explaining my point - so sorry about that!!

I know that any member can and will offer average pricing, we did ourselves, that is easy if you have a lot of clients. My point is just that average pricing relies on you trading every deliverable day in a month to get the average price. If you just tried to trade 'september' you cant. The fact that you have to price every day, and then at the end of the month get the average means you have to be able to trade a minimum of one lot per day as you cannot trade a fraction of a lot is all.

 

[BREND]

I am obviously rubbish at explaining my point - so sorry about that!!

I know that any member can and will offer average pricing, we did ourselves, that is easy if you have a lot of clients. My point is just that average pricing relies on you trading every deliverable day in a month to get the average price. If you just tried to trade 'september' you cant. The fact that you have to price every day, and then at the end of the month get the average means you have to be able to trade a minimum of one lot per day as you cannot trade a fraction of a lot is all.

Yawn. Ok ok.