Commodity Trading risks go hand in hand with the monetary benefits of commodity trading. When you are dealing in the commodities segment, there is no such thing as a risk-free trade. The merrier the profit seems in the trade, the higher the chances of risks.
However, if you are cautious enough, most of the risks that are present in commodities are easily avoidable. Even if at times you cannot avoid risk, there are ways in which you can minimize your losses in each of these scenarios.
Therefore, in this detailed review, we would discuss commodity trading risks and how to avoid them.
Trading, in general, involves many types of risks. If you are running a business, you would be controlling the flow of products as well as services.
General business trading, as compared to commodity trading through exchanges, involve taking of deliveries. You need to arrange for transportation of commodities as well as their storage. While these incur their own costs, this also opens up a number of risks.
There is always the chance of transportation going awry or getting problems while storage. A rat infestation can spoil your wheat storage. A power failure can disrupt a cold storage facility for crops and vegetables. There is a risk of fire breaking out while dealing with gasoline and natural gas.
Similarly, commodity trading has its own risks as well. While the risks in general trading can be out of your control and lead to uncontrolled losses, the commodity trading risks can be easily managed.
Commodity Trading Risks
Commodity trading risks are based on factors that are present in a commodity trading contract that can bring up a loss in that contract.
Some of such risks are prevalent to particular commodities. Other risks are present in all commodities (including the top commodities you might already be investing in) in general and they might influence particular commodities more than the others.
There are a few commodity trading risks that cannot be eliminated. However, there are ways and tricks to handle each one of them. We will discuss all of these ways in this review.
Here are the various types of risks that are present in commodity trading:
Commodity Trading Risks #1 – Volatility:
The volatility of commodities is the primary reason that people invest in them. Price of the commodities can fluctuate on a momentary basis. People invest in commodities to make profits from these very fluctuations.
As they say, the greatest boon can sometimes be the biggest curse as well.
In the same manner, volatility is the biggest risk factor in commodity trading. The price of commodities can take a dip at any time. This can turn into a huge loss for people who were hoping for the opposite.
For example: Suppose you invested in some bullions of Gold hoping that the price would go up the next day (read Gold Commodity Trading). However, on the contrary, owing to the day to day fluctuations in price, the price of gold falls down the next day. This could mean that you have suffered a loss in the contract.
While all commodities, by their very nature, are volatile, this risk factor is more prominent in some commodities than the others. Precious metals like gold and silver tend to be more volatile than raw materials like steel.
The prices of commodities can even fluctuate to 200% or 50% or value in a very short amount of time.
This is the factor that lures most people in the trade. If the price of commodity doubles or triples in value, people are going to make a lot of profit. However, people often fail to acknowledge that by this very reasoning, prices can also halve and wipe out their entire investment.
Managing volatility of commodities is entirely up to a trader. Unless any catastrophic event takes place, the prices of commodities are influenced by various factors. Before jumping into the trade, a trader should research about the commodity he is dealing with.
This is a lot of hard work and requires a good effort on account of the trader. There are government policies, weather reports, transportation policies, etc. to learn to pertain to the commodity.
Further, commodities tend to follow trends. So, a trader should also look into the past trends of the commodity and see how the commodity behaves. If a trader does his homework properly, the risk of volatility can turn into an asset for the trader and he can make the most out of it.
Also, keeping constant attention on the market is another good way to minimize these losses. Successful traders always have an eye out on what is happening in the market. Nothing evades their attention. This is why they end up making an overall profit every year out.
Commodity Trading Risks #2- Leverage:
Commodity trading gives a great gift to a trader in terms of leverage. However, this gift is often misused by novice traders and it turns into a commodity trading risk.
Margin or leverage is the amount of money you deposit as a down payment for the actual price of the commodity. For example, if the price of a commodity is ₹1,000 and there is a leverage of 20%, you would only have to put in ₹200 for the commodity.
This doesn’t mean that the remaining money is for granted. Think of it as a loan from the commodity exchange.
So, if the price of the commodity goes up by 20%, that is, it changes to ₹1200, you have received a profit of ₹200 and doubled your investment.
However, If the price of the commodity goes down by 20%, i.e., it becomes ₹800, your entire investment is wiped out.
Most traders cannot handle this gift of leverage properly. If the margin is of 10%, they might buy 10 contracts of ₹1000 to control ₹1,00,000.
However, what they don’t realize is that while it is a good shot at a profit, even small fluctuation in a market will wipe out their entire investment.
The best way to handle margin risks is to not invest all your money altogether.
Invest small quantities in a diversified list of commodities. If one of the commodities takes a dip, the other might keep your investment alive. For example, if you are a gold trader, you can also invest in silver as well.
Also, if you are a beginner trader, hold a smaller number of contracts of any particular commodity. While having more contracts enhances the profit you might make, it also multiplies the chances and amount of losses.
Commodity Trading Risks #3 – Inexperience:
Inexperience is by far the biggest risk for a commodity trader.
Many people jump into commodity trading without even knowing the basics of commodity trading. They are influenced by their friends, relatives, or the media about how commodity trading is the easiest way to become rich quickly.
With the lack of experience, they make haphazard decisions in the beginning. They invest too much capital in all the wrong areas. The end result: most of them end up wiping out their entire capital in the first few trades.
The field of commodity trading is a science in itself. Most successful commodity traders with years of experience in trading still consider themselves to be in the learning stage. Therefore, it is a wrong notion to consider oneself adept for the field just by reading an article or listening to a story.
Since inexperience is a commodity trading risk on the side of the trader, it can be best managed by the trader himself. Before making the first trade, it is essential to know about the basics of commodity trading.
One should know about the commodity in which he should invest, how much he should invest, and when he should invest it. One needs to research the past trends of the commodity and the factor that influence it. When starting, it is best to start small.
See how the market functions.
You should understand the peaks and the dips of the market. Analyse everything carefully and you would be ready to make the first trade. As they say, the best experience comes from doing it yourself. Therefore, learn while you trade and make sure that you can handle the losses that you incur.
Commodity Trading Risks #4- Emotional Influence:
While commodity trading decisions should be done after careful analysis of the market, traders often make decisions influenced by their own emotions. Many times, people are unable to accept a loss.
They keep on holding on to their contracts in hope of a profit just because they want to avoid realizing the fact that they made a wrong decision. At times, even after losing, people high up their stakes just in order to make up for the losses they have incurred.
This leads to suffering bigger losses.
At times, people get so influenced by their emotions than to make up for the losses, they start borrowing money to invest in commodity trading. This not only results in further, loss, but the person can get deep into debt.
Commodity trading can become an addiction very easily, therefore it is essential for one to have control over it.
Emotional influence is one of the commodity trading risks that can be handled by the person itself. The person needs to realize that while investing in commodities, losses are an integral part. He can face losses at any time and of any amount.
While the losses can be avoided or their chances can be reduced, one still needs the ability to handle losses when they come. If you feel you cannot handle losses or the stress they bring, commodity trading isn’t for you.
Further, one needs to pre-set the amount of money he can spare for commodity trading. While setting this amount, make sure that you are only counting the spare money you have and you are not borrowing from anyone.
Commodity Trading Risks #5- Unforeseen Risks:
Unforeseen risks are an important part of commodity trading. These risks are the hardest to handle as one cannot predict them in advance.
Unforeseen risks involve a random third-party event occurring that causes the price of a commodity to increase or decrease rapidly. These events could be natural or man-made factors that can happen at any time to any commodity.
These events include earthquakes, unexpected rainfalls, droughts, sudden government policies, business events, natural disasters, etc.
For example, when poultry diseases like bird flu become prevalent, people stop purchasing poultry items like chicken meat and eggs. This leads to a sharp decline in demand and the prices falling down considerably.
In another example, with the demonetization policy of the Indian government, the prices of gold fell considerably as the demand reduced. Other precious metal commodities suffered as well.
Therefore, these risks are not in control of a trader and they have no foreseen onset. These cannot be predicted by an expert in the field. Hence, one cannot eliminate this type of risk.
However, one can always be prepared for it.
The best way to handle unforeseen risks is to be prepared.
You should be ready to take losses in an unforeseen event. This is why experienced traders only invest the ‘extra’ money they have in commodity trading. You should never trade in commodities with your day to day expenses.
Also, it is always a good idea to keep some extra money aside for a rainy day.
Additionally, you should never invest all your capital at a single time. Invest in phases across multiple commodities in the same field.
Additional Risk Management Strategies:
Stop Loss: The best advantage of commodity trading is that you can easily manage your losses. Stop losses is like a command given to the broker that automatically sells your contracts once they dip below a certain point. This is done as an effective strategy to minimize and limit the losses.
Margin Call: Margin calls are events where a broker would ask you to put more money in the account to keep up the share of equity you purchased in a commodity.
This is done in case the price of certain contracts you own have fallen and dipped your capital, and you need more maintain your share of the commodity. Margin calls are signs that you are losing money and you should never answer them.
These commodity trading risks are an inherent part of commodity trading and you should always take them into account while making decisions. If you handle them well, you will be one of the successful traders you have heard stories about!
In case you are looking to put your feet into commodity trading or stock market investments in general, let us assist you in taking the next steps forward: