Asset management, Behavioral finance, Commodity price, Commodity risk, Economics, Hedging, Market research, Market trends, Psychology, Risk management, trend following

Harnessing market trends to manage commodity price risk

On 24th September 2015, David Stein (M Sc., CFA, President and CEO of Aberdeen International[1]) wrote a compelling article analyzing the expected effect of last year’s VolksWagen emissions scandal on palladium and platinum markets that should be of great interest to commodity traders and industry.

Platinum and palladium are used in catalytic converters for cars to convert the pollutants from gasoline or diesel engines into less toxic substances, thereby reducing toxic emissions. In 1970s, early platinum catalytic converters were essentially containers filled with platinum-coated pellets. In order to reduce the amount of expensive metal needed in converters, the industry developed advanced high-tech ceramic honeycomb lattices very thinly coated with platinum. They further improved emissions standards at no extra cost in precious metals by installing special software in new cars electronics. This software could recognize when an emission test was being conducted and respond by altering the engine’s operation in order to lower engine emissions. This gimmick effectively enabled auto makers to cheat on emission tests, and together with the genuine improvements in catalytic converters it helped car manufacturers to reduce the amount of platinum required to meet legal emissions standards to about 3 grams, or about $100 per car.

When auto makers’ cheating came to light with the VW emissions scandal, it turned out that without the software gimmicks emissions systems fell 10 to 40 times short of legal requirements (VW was not the only auto maker guilty of cheating). Many observers now expected that auto manufacturers would be obliged to improve their emissions standards by upping the amount of platinum or palladium in catalytic converters. To just double their emissions efficiency, VW alone would need to purchase over 2 million ounces of the metal. It would need a lot more to attain full compliance.

This, in essence, was the idea behind David Stein’s analysis and it had one clear implication for platinum: the price of the precious metal, trading at that time near their 2008 lows, could be expected to vault much, much higher. For a commodity price speculator, this could be a great trading opportunity. Unfortunately, as obvious and compelling as David Stein’s case appears, things are never quite that simple in the world of commodity trading.

Suppose you found Mr. Stein’s analysis compelling enough to go ahead and buy platinum futures. At the time, the initial margin requirement to trade the 50-ounce NYMEX platinum contract was $2,100. With that sum deposited to your margin account, you could trade one contract, or 50 ounces of the metal. On 24th September, platinum traded at $955.10 per ounce, but then fell nearly $50/oz over the following five days. If you bought on the 24th of September, by 1st October 2015 you would have lost $2,495 per contract. And then it got worse: platinum price continued sliding and by 20th January 2016, fell to a low of $819.20 translating into a loss of nearly $6,800 per contract. From this point, platinum prices did appreciate significantly, but you would need to wait nearly six months just to recover your losses. For discretionary traders, this is extremely difficult to do. In my book “Mastering Uncertainty in Commodities Trading” I explained in some detail the psychological loss aversion bias which makes bearing such losses for that long very unlikely.

A commodity trader equipped with a good market analysis but bad timing and overly aggressive position sizing, could get wiped out very quickly, unable to profit from the price move he anticipated. To avoid such outcomes two key elements are necessary. The first addresses risk: although NYMEX might allow you to trade Platinum with as little as $2,100 per contract, a prudent trader should allocate much more cash to his margin account to accommodate likely losses on his positions. Second element addresses uncertainty and calls for improved market timing.

While there is no one best answer to the problem of uncertainty, trend followers prefer to rely on systematic trading strategies to manage directional price exposure and timing of trades. In our concrete example with platinum, a trend follower would essentially ignore the fundamental analysis and trade according to the prevailing market trend. At Altana Wealth, I use 18 individual systematic trend following strategies to trade platinum. These differ mainly in the length of the trend cycle (long term, medium term, or short-term trends) and time in the market (either always in position, or more opportunistically entering and exiting positions to take advantage of shorter-term market fluctuations). The chart below shows these strategies performance over the period in question and compares them with the discretionary long-only position a trader would hold if he bought platinum futures on 24th September 2015. Each trading strategy, including the discretionary long trade, uses a risk budget of $25,000 per contract of Platinum (nearly 12 times the minimum margin requirement):

20160821_pl_discretionary_vs_systematic

From 24th September 2015 through 19th August 2016, the long-only discretionary trade would have outperformed the systematic approach, but only if the trader maintained his positions unchanged through the first six months of very substantial losses. This is not realistic. Nursing losses for that long is psychologically very difficult, and the urge to do something to reverse the losses could be next to irresistible. The discretionary trader could lose confidence in his judgment and analysis, close out or reverse his positions at the wrong moment or even gamble with additional risk. Such manoeuvres often worsen the outcome, adding to financial losses, emotional distress and psychological pressure to fix the situation. Here, the discretionary trader is extremely vulnerable, even where his analysis ultimately proves correct.

Systematic trading sidesteps these difficulties and provides traders the luxury of discipline and consistency regardless of their opinions or emotional states. While there will always be examples where discretionary traders outperform, there can be little doubt that over the long term, systematic trend following is more reliable (provided it is based on a well formulated model). At least one empirical study corroborates this. Namely, analyzing a large sample of commodity trading hedge funds between 1994 and 2009, Julia Arnold of the Imperial College in London found that systematic funds had 50% greater longevity than discretionary ones: 12 years vs. 8 years. This is one of the many reasons why we continue using and advocating systematic approach to speculation as the more dependable way to implement trading and hedging strategies for commodity firms as well as for traders and investors.

Alex Krainer is an author and hedge fund manager based in Monaco. Recently he has published the book “Mastering Uncertainty in Commodities Trading“.

Notes:

[1] Aberdeen International is a publicly traded asset manager focused on mining investments.

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