commodity trading

I recenlty got an opportunity to be a commodity trader. I heard this trading is really risky. Could you please give some advice on this, is this a good career move?

what are you doing right now?

I used to be a programmer and now in school finishing a MFE degree. My goal is to be an asset manager eventually.

Commodity trading can be very risky if you are trading commodity futures, which have risks associated with high leverage if you don’t manage them properly. Basically, you need to imagine your position size as 10x to 20x your actual cash outlay. Manage your money effectively so that no more than 1% or so of your capital is exposed to any specific (or correlated) bets, and you can play it safe. Commodities have fundamentals which are simpler in theory, because they don’t involve company management decisions about operations and capital structure, but more obscure in practice, because it is hard to get a good grip on global or regional supply and demand, and there aren’t really a bunch of financial statements to serve as a data source. Expected return on commodities is related to the relative growth of supply and demand and to seasonal effects. Commodities are attractive to portfolio investors because some of them have very low correlations to other asset classes and help to diversify portfolios, hence the demand for CTAs. However, most commodities (outside of precious metals and energy) have fairly low average rates of return, so if you are a trader, you may need to use more technical analysis on short and mid-term trading, instead of the usual CFA orthodoxy on portfolio construction (which is fine for more institutional types, but not suitable for commodity traders, as far as I can tell).

Being a commodity trader is great. It’s as risky as you want it to be. As the risk manager for a commodity trading shop for years, I had more trouble getting people to take on a decent amount of risk than I did putting a lid on the risk. That said, it’s a tough game because it’s so dependent on truly random things (weather, war, planes hitting buildings). Do you know anything about commodities?

I know commodity trading is future trading. I know basics about futures however I don’t know specific commodities.

It’s the psychology of futures trading that can suck you in. You make the right call with a future and double your cash outlay, you suddenly think you’re a genius and think “I should have risked more.” Next thing you know you lose 30% of your capital on a bad trade because you risked 10% on a sure thing that went against you. Now you’re down to 70% of your previous capital and are getting nervous. To get back to your initial position, you figure that you’d better start making bigger bets to get back to your initial capital, which requires a 43% recovery, even though your loss was only 30%. You might succeed with that strategy, but if you bet wrong, you’re down even further. Moreover, you’re now nervous about what your P&L will look like at the end of the day/week/month, and this clouds your thinking. You can no longer wait for the good trades, you have to maximize whatever is coming your way now. Hopefully you will work with someone like Joey who will tap you on the shoulder and tell you to take a week or two off before trading again. And of course, if you need to bring your own money to trade, then your equity is likely to be the first to be wiped out. So that’s the risk of trading most futures, commodity or not. What’s tricky about commodities is the bit about how you don’t often have as much information circulating about a commodity as you do about a company, so it’s harder to make “informed choices.” Now, that may actually not be such a bad thing, since a number of traders have said (see Curtis Faith, “The Way of the Turtle”) that what screws a lot of traders up is trying to predict where the market “should” go. Having that hypothesis takes time and energy away from the more critical question of “how do you react to the way the market just moved.” And if someone in Joey’s position tells you that you aren’t taking enough risk… well, that means you’re probably being pretty smart, and should work out with him what a sensible risk level should be.

Except they all get fired because they take on 40 bp/day of VaR and aren’t worth the trouble…

JDV - do you know of any good commodity trading shops (investment managers or prop firms) on the west coast, or any idea of where to search to find one?

I’ve heard good things about Sunrise Capital Management which is somewhere in CA. My bud who sells them software thinks it would be a great place to work.

Sunrise Capital? Sounds like they’re a little light in the loafers. You know what would be a good name? Greyskull Capital. Sounds like an alpha machine!

Thanks JDV

lol HoldSide