A robust market is not just judged by the availability of trading products and a regulatory mechanism but also by the quality of participants in the market. The same is the case with commodity futures market too. While there are thousands of traders who are trading in and out of various precious metals, industrial metals and agricultural commodities, these traders and participants can be broadly classified into four broad categories. This classification is very important as each of these categories of participants has a unique imprint on the market and contributes to the robustness of the market in their own way.
1. Commodity market speculators
Speculators are there in the market for a very short period of time. They may look to exit their long / short position within the same day or may look to exit in a few days time. They operate on thin margins, leveraged trades and rapid churning of funds. Speculators are also popularly referred to as intraday traders in the equity derivatives market. Speculators are largely agnostic to direction of the market and are willing to trade both ways i.e. on the long side and on the short side. Speculators typically try to ensure that they are on the side of the momentum of the market overall and the specific commodity they are trading. Since speculators rely heavily on minor trading opportunities in the commodity trading markets, they extensively base their speculative trades on technical charts, supports, resistances, break-outs, patterns etc. Speculators have a very important role to play in the commodity markets in the sense that they provide liquidity in the markets and also ensure that the bid-ask spreads are kept at the bare minimum.
2. Directional Margin Traders
These traders have a slightly longer term view on specific commodities compared to speculators who typically operate at the short end of the market. Margin traders use futures as a proxy for buying the commodity in the sport market as the benefit of margin trading is available in the futures market. Instead of locking up their entire capital in holding to a spot position, the margin traders use futures as a proxy for spot positions by paying a margin. Margin traders are not only willing to wait till expiry but are also willing to take a longer period contract and even to bear the rollover cost for carrying forward the position. Margin traders normally do not rely too much on technicals but have a very strong fundamental premise due to which they are willing to bear the roll cost to carry the position longer. The trades of these margin traders typically give hints to traders and analysts regarding which commodities are attracting long term interest and acting as a lead indicator of underlying shifts?
3. Spot / Futures Arbitrageurs
Arbitrageurs play a very unique role in the commodity markets. They actually even out the pricing inefficiencies in the market but trying to lock in spreads. Before understanding how arbitrageurs operate in the commodity markets, let us first understand how they operate in the equity markets. If Tata Motors is quoting at Rs.440 in the spot market and at Rs.449 in the stock futures market, then the arbitrageur will buy Tata Motors at Rs.440 in the spot market and sell Tata Motors Futures at Rs.449. That way he can lock in an assured profit of Rs.9 (2% ROI) for one month. On the expiry day, the spot and futures position will expire at the same price enabling the arbitrageur to realize the 2% spread. Commodity markets can be slightly more complicated. Firstly, the spot and futures market in commodities are regulating by different regulators which makes it more complicated. Secondly, unlike equities, commodities have additional costs in the form of transportation charges, insurance costs, storage charges, stamp duty etc and all this will have to be factored in when calculating the spread. However, the bottom-line is that if the arbitrage spread on any commodity is positive after considering all these costs, then the arbitrageur will buy in the spot and sell in the futures. By ironing out any pricing anomalies, the arbitrageur will not only make an assured profit but will also ensure that the market becomes more efficient in the process. Arbitrage requires much more resources compared to speculating or margin trading.
4. Commodity price hedgers
Hedgers are those participants who have an underlying exposure to a particularly commodity. Let us assume that you have a large order of silver that you need to deliver to a jeweller after 3 months. The only problem is that the deal will be done at the prevailing price on that date. That exposes you to the price risk over the next 3 months. You are quite satisfied with the price of silver today but you are apprehensive that 3 months down the line the price of silver may be lower. You can hedge by selling 3-month silver futures short. By doing so you are locking in your position at a price that is prima facie attractive to you. You are therefore indifferent to the price movement of silver over the next 3 months. Of course, you will incur a notional loss if the price of silver goes up but that is the job of a speculator. As a hedger, your job is to protect your downside risk and that is something you have managed effectively. Hedgers are traders with genuine exposure to the underlying market and hence lend stability and credibility to the commodity markets.
These four participants actually form the four pillars of the commodity markets. It is the joint actions of these four participants that determines the direction and robustness of the commodity markets.