Hedging on Mettalex: Commodities Trading
Jul 9, 2021
Introduction to Hedging
If you have followed Mettalex’s hedging-dedicated series, you should already know that hedging is an essential portfolio management skill that you should develop. If not, consider going through the explainer blog post on what hedging is, and educate yourself on the most popular hedging instruments, namely options and futures contracts.
This last part of the series will focus on commodities – what commodity trading is, who can do it and where, and what requirements should be satisfied beforehand. In addition, we’ll distinguish between traditional commodity markets and trading on Mettalex to demonstrate all the platform’s advantages.
What are Commodities?
Commodities may be both basic goods used in everyday life, and raw materials employed in manufacturing. They are essential in a variety of industries including food production, transportation, construction, and many more.
Commodities generally fall into four main categories:
- Metals – these can be metals and alloys used in manufacturing, construction, transportation, such as copper, aluminium, and steel, as well as precious metals like gold and silver.
- Energy – this category encompasses fossil fuels such as crude oil, natural gas, and gasoline.
- Agriculture – agricultural commodities include soybean, corn, coffee, cocoa, wheat, sugar, and more.
- Livestock – this category covers different types of meat and cattle.
What is Commodity Trading?
Commodities are the oldest form of financial instruments. Even before the invention of money, in times of bartering, people exchanged one good for another, be it agricultural products, livestock, spices, textile.
Today, commodities represent an important class in the global trade ecosystem. They can be traded either on the spot market or the derivatives market.
Spot commodity refers to buying and selling commodities at their current price with delivery and transaction settlement happening in a matter of days. In contrast, derivatives markets offer futures and forward contracts that have the given commodity as an underlying asset and arrange delivery (or not) in the future. More on them below.
Who is Trading Commodities?
In general, entities that use commodities as the input to their business activity are the main players in the commodity markets. These can be farmers, manufacturers, transportation, electronics, pharmaceutical companies, etc. However, speculators have also entered the commodities market to diversify their portfolios.
Speculators trade both on the spot and the derivatives markets but usually pursue different goals. Those interested in acquiring or selling the commodity itself try either to guarantee an affordable supply of raw materials, fuels, or crops input or to ensure their final product would be sold in the market at a satisfactory price. On the other hand, speculators’ main goal is to exploit adverse price movements to generate profits, without ever getting delivery of the commodity itself.
There are several types of financial instruments that one can use to enter the commodity markets. They offer different levels of exposure to the underlying asset’s price movements.
For instance, you can invest in equity of public companies that are directly involved in producing or exploiting commodities, such as oil refineries or mining companies. You can also buy into ETFs, ETNs, or mutual funds that have holdings in such businesses and industries. However, the financial viability of such companies and their performance on the stock market may depend on many other factors apart from the behavior of the commodity’s price.
On the other hand, derivatives such as Options, Futures, and Forwards can be used to directly exploit the price movement and volatility of a given commodity or to guarantee its delivery or sale at affordable prices. Futures are the most popular and commonly used tool. Forward contracts are quite similar to futures, except that they are customizable agreements made over-the-counter between two parties, and not traded on an exchange.
Why Trading Commodity Derivatives?
Trading commodities is quite popular for several reasons. Apart from the motives outlined above – guaranteeing affordability and generating profits, investors and speculators opt for commodity derivatives because of the numerous advantages they can offer. We will highlight the most common cases in which trading commodities is a must:
- First and foremost, commodities are the preferred hedging instrument. No matter what you are trying to protect your portfolio against, commodity derivatives can offer a safe haven.
- Commodities are an efficient inflation hedge
Usually, commodity derivatives have close to no correlation with financial classes such as bonds and stocks and their price even tends to move in the opposite direction. For example, extremely high inflation sends a bad signal to stock markets but acts beneficially to commodity securities, something we have been witnessing over the past year.
- Commodities are often used to store value in times of global crises and turbulence
Unpredictable events such as natural disasters, wars, and crises similar to the Covid-19 one tend to boost commodity derivatives prices since they have a direct impact on commodity supply and demand cycles.
- Using leverage in commodity trading is much more common than in stocks.
That means that one would need to commit only a percentage of the derivative’s full price to invest in it. If an oil futures contract costs $50,000, an investor would pay only 10% or $5,000 to enter the contract. Therefore, commodity trading requires a smaller initial investment but may generate significant gains. However, leveraged commodity exposure is considered a high-risk investment since even a small price swing may result in large losses. In addition, leverage trading is linked to minimum and maintenance margin requirements and the risk of margin calls and position liquidations always stands.
- Commodities are frequently used in portfolio diversification.
A traditional cash instruments trader may invest part of their portfolio into commodity derivatives to diversify their risk exposure. This is a common practice, although committing more than 20% may be potentially dangerous.
Let’s try to clarify why trading commodities may hide unforeseen risks. In principle, commodity prices are governed mainly by supply and demand. Thus, one should consider and investigate all the factors that may influence a commodity’s production and offering before they start trading.
Let’s take the metal commodities as an example. The huge demand for metals used in construction coming from emerging countries like China and India combined with temporary supply shortages have recently led to a significant increase in prices. Meanwhile, surging decarbonization trends may gradually intensify the demand for environmentally-friendly steel production, resulting in closing steel mills and disrupting manufacturing cycles.
The same goes for the energy commodities – people are resuming to travel with the easing of Covid-19 measures which will increase the demand for fossil fuels. However, renewable energy sources like solar and wind are getting cheaper and more popular, taking an ever-larger share in developed countries’ energy mix.
These examples just go to show that commodity trading should be undertaken with caution and require deep knowledge, research, and analysis of commodities and their price behavior. Everything from financial crises and currency destabilization, to climate change and man-made catastrophes may impact commodity markets.
Commodity Exchanges and Requirements
Commodity exchanges are the institutions that make trading of commodities-based financial instruments possible by enforcing certain rules and standards. Some exchanges specialize in a single category of commodities, others offer different kinds.
The most popular exchanges in the USA are the Chicago Mercantile Exchange (CME), the New York Mercantile Exchange (NYMEX), the Intercontinental Exchange (ICE) in Atlanta, Georgia, and the Kansas City Board of Trade. In Europe, there is the London Metal Exchange (LME) which is the only physical commodity exchange left since all the rest are now electronic.
As we outlined already in previous blog posts on Options and Futures, trading such instruments is not accessible to everyone. Individuals who would like to trade commodity derivatives need to do so through a brokerage firm that should be a member of the exchange in question. In addition, even if you strike a deal with a broker, you may still not be eligible to trade futures contracts and will need to go through an extensive approval procedure. Moreover, most commodity futures are bought on margin, so you will be obliged to have an initial margin account and satisfy the requirements for maintenance margin throughout your trading. Otherwise, you may face margin calls and liquidation of your open positions. Overall, you are at the mercy of your broker.
Also, as we mentioned already, when trading commodity futures high levels of leverage are used, and since it involves debt or borrowed capital, it amplifies gains as well as losses.
In conclusion, traditional commodity derivatives trading requires specialized knowledge and could be an expensive endeavor, involving several intermediaries and the deposit of significant amounts of capital long before any trading is initiated.
How Trading on Mettalex is Different?
The Mettalex decentralized exchange is bringing commodity derivatives to DeFi to democratize traditional commodities trading and abolish several inherent constraints and limitations. Mettalex opens the doors to commodity derivatives to anyone by forwarding crypto liquidity to traditionally illiquid markets.
Mettalex may not be the perfect solution for commodity retailers since there is no physical delivery of commodities. However, the DEX offers orders of magnitude more user-friendly and cost and capital efficient access for hedgers and speculators. Here’s why:
- There is no need to use a brokerage firm or any other type of intermediary to trade on Mettalex.
- The margin requirements on Mettalex are fixed i.e. no need to maintain a predetermined margin or to fear margin calls. Once a position is opened, either short or long, no further capital is needed.
- Open positions on Mettalex do not expire at a predetermined date (like in the case of both options and futures contracts). They get automatically settled only if the price band is breached or if the trader sells them back to the AMM.
- On Mettalex leverage is achieved by the token price being a fraction of the asset price. This leverage enables hedgers to manage their risk exposure at a minimal cost. Significant gains can be recorded even without borrowing additional capital.
- The risk is 100% quantified. Users know exactly how much they can lose or earn even before opening a position.
- The exposure to price movements is capped thanks to the price band within which all trades are done.
- Settlement of positions on Mettalex is done only in stablecoins. Since there is no physical delivery of assets, no transportation or storage costs are required.
- Currently, there is no lengthy user-identification process.
- Hedging via traditional commodity futures may result in a hedger missing out on favorable price movements since the futures contract is fixed. In contrast, on Mettalex, you can easily switch between a long and a short position, with just a few clicks and minimum trading fees.
And here are a few more, blockchain-specific advantages that Mettalex offers:
- The Mettalex team has no access to user funds. Every position on the DEX is fully collateralized in stablecoins stored in non-custodial smart contracts.
- The Mettalex UI is much easier to use than any other derivatives platform in the DeFi space.
- Mettalex is available everywhere in the world and currently, users can only be identified by their Binance Smart Chain wallet addresses.*
- No single company provides liquidity on Mettalex, it is peer-generated.
- There is no daily settlement of gains and losses.
- Similar to crypto futures, but unlike the traditional commodity ones, Mettalex is available at all times, every single day, 24/7.
- Mettalex combines the best of both worlds – cryptocurrencies and commodity derivatives.
Mettalex allows you to easily profit from a given commodity’s volatility without excessive initial investment or sharing your gains (but not losses) with intermediaries. All you need to do is go to dex.mettalex.com, choose your preferred market, and swap your BUSD or USDT for a short or a long position.
Mettalex is democratizing the trading process in a groundbreaking way and is making hedging much more straightforward. Don’t waste any more time and try it out. Happy trading!
If you are curious to learn more on commodity trading, check out the first episode of our Mettacast series of events with special guest Phillip Price – long-time metal commodities trader and strategist:
NOTE: Trading on Mettalex is not in any way riskless. Please refer to this article for more information.
*Excluding users from the U.S.