Fundamentals Of Commodities

Course Structure• Course Aims

– To promote the interests of PMEX and to get people interested in safe and successful commodity trading

• Course Theory– All theory will be geared towards promoting the present & future commodities trading

on the PMEX.• Practical Aspect Of Commodities

– Understanding PMEX. Its working and trading platform– Ways to trade on PMEX– How to open an account– How to read the screen– Understanding and learning the PMEX website– Trip to the PMEX – to show students First Hand what its all about

• Visits from PMEX Marketers and Trainers will be welcomed throughout the course• Certificates will be given at the end of course with PMEX accreditation• All help, advice, suggestions and support from THE PMEX will be welcomed AND Appreciated

Basic Trading Terminologies

• Long• Bid• Margins• Initial Margin• Maintenance Margin• Variation Margin• Business Day• Exposure Limits• Delivery• Open Interest

• Short• Ask• Last Traded Price• Volume Of Trading• Spot Price• Future Price• Bull Market• Bear Market

Basic Concepts

• TRADE SAFETY– Risks and benefits of Trading– Importance of Risk Management; Stop Loss– Benefits of understanding and researching

markets/exchanges/commodities before trading• Benefits Of trading on the PMEX• Profit Objectives• Trading On Technicals• Trading on Fundamentals• Day Trading

What are Commodities and How are we affected by them?

• Types of Commodities– Metals

• Non-precious metals = lead, copper, aluminum, nickel – these are usually used by manufacturers

• Precious metals = Gold, Silver, Palladium, Platinum• These are known as hard commodities and the trade on specialized

exchanges

– Soft Commodities• Agricultural – wheat, corn, sugar, coffee• Energy – oil, gas, coal

• We are affected by commodities markets:– Every time we buy a packet of tea, a cup of coffee– Every time we buy petrol

What makes Commodities Different (from Stocks)

• Key Features– High risk– Lower liquidity– They can be stolen & they can perish– Delivery is more complicated and less secure (ships sink/lorries crash)– Are affected by politics– Are affected by weather– Most are subject to seasonal demand– Are Highly volatile– Expropriations risk– Environmental regulations– Strength of trade unions

Review Of Derivatives

Types Of People Involved in Derivatives

• Hedgers – or those who use derivatives for risk reduction. They may be producers of the physical commodity, marketers, large end users – are those market participants who buy and/or sell the assets upon which the derivatives are based,– They use derivatives primarily to protect against declining values of

either current commodity inventories or future production• Speculaters –generally do not have any use for the derivatives’

underlying assets.– They use derivatives as a way to potentially profit from an expected

change in the price of the underlying asset and offset any obligations that may arise out of the derivative contracts before they expire.

• Speculators Assume the risk that hedgers offset

Futures Contracts• Agreements between two parties to buy or sell an asset as some

point at a predetermined price. • They trade on a regulated exchange and terms of these contracts

are standardized.• All contracts are guaranteed by a third-party clearinghouse

associated with the exchange upon which they trade.• The initial value of all contracts are zero, the contracts gain value

only if the futures price changes.• Contracts have a daily settlement feature – marking-to-market.• All futures contracts are standardized in terms of their size, grade,

and time and place of delivery, trading hours and minimum price fluctuations

Offsetting

• An offsetting transaction is accomplished when the holder of a long position independently sells the contract (or contracts), or the holder of a short position independently buys back the contract (or contracts)

• Payoff From the long: (offset price – Entry price) * contract size * Number of Contracts

• Payoff From the Short: (Entry Price – Offset Price) *Contract size * Number Of Contracts

A Typical Futures Trade

• A trader places an order with a futures broker to buy 1 July Gold (1 ounce) Futures contracts on the PMEX. The order is filled at a price of $1494.00 .Let’s suppose the current exchange rate is 85 rupees. The contract will cost the trader 1494*85 =126990 rupees. The Initial margin/token money for this contract is 3.25% of the total amount which will be 126990*3.25% = 4127 rupees. Lets suppose the price of Gold moves up to $1495 and the trader places an order with the same broker to sell 1 July Gold (1 ounce) Futures contract. The trader will then make $1*85 = 85 rupees as profit.

Rolling Over a Position

• Market Participants who still want to maintain the same exposure to a particular underlying asset can roll over the position into a more distant delivery month by offsetting the old contract while simultaneously entering into a deferred contract month

Margin Requirements & Marking-to-Market

• Futures margin is an amount of money that a customer must deposit with a broker to provide a level of assurance that the financial obligations of the futures contract will be met.

• Minimum margin rate for a client who wants to establish a position in a futures market is set by the exchange or clearinghouse, but a member firm may impose higher margin rates on its clients.

• Two levels of margin are used in futures trading: initial/original margin and maintenance margin. Original margin represents the deposit that is required when parties first enter into a futures contract.

• Maintenance margin is the minimum balance for the margin required during the life of the contract.

• Marking-to-Market=at the end of each trading day, the holder of a long position makes a payment to the holder of a short position, or vice versa, depending on the relationship between the current futures price and the initial entry price.

• Long and short accounts are debited or credited each day by the amount of the day’s loss or gain. The party who is in the losing position will have to deposit additional margin only when his or her account balance falls below the maintenance margin level.

Introduction To Gold and Silver

Why should one invest in Gold?

• Provides a safe haven for investors for the flight of capital from risky markets

• Is seen as a hedge against inflation• Purchasing power of strong currencies continues to

fall – a hedge against currency weakness/devaluation• War on terrorism – the only thing that will maintain

value is Gold – its seen as a hedge against Geo-Political Uncertainty

• Its demand & price has risen throughout time• To attain Portfolio Diversification

Sources Of Gold Demand• Jewelry

– Gold use in Jewelry is often Negatively Correlated with a rise in Gold Prices

• Industrial Demand– Used in electronic components– Used in the medical industry– Used for a number of decorative purposes

• New Uses Of Gold– Used as a catalyst in fuel cells– Used as a chemical processing agent

• Investment Demand– Retail– Institutional

Sources Of Gold Supply

• Mine Production– China is the largest producer and South Africa is

the second largest• Gold Scrap And Recycling • Central Bank Sales

Risks And Costs Of Investing In Gold

• Pays no dividends• There are costs to be incurred in safe keeping• Gold does not Always provide an effective

hedge against recession

Silver as An Investment• Silver is considered a precious metal but not as rare as gold.• Silver is used in the production of coins, but not nearly as much

since the 1960s.• Silver is also considered an industrial metal where about half of the

US production of silver is used in photographic film. Silver is also used in the production of many electrical devices and of course jewelry.

• Most newly mined silver comes from Mexico, Peru, Canada, the US, Australia and Russia. Silver production also comes from the recycling of camera and x-ray films, jewelry and melting of silver coins - especially when the price of silver has been rising.

• Silver And Gold Usually Trend Together and are affected by the same supply and demand factors

A Typical Silver Transaction• A trader places an order with a futures broker to buy 10 July silver

futures contracts (500 troy ounces). The order is filled at $35. Assume the exchange rate is 85 rupees. And the Initial margin percentage is 10%

• The Initial Margin is 10% of $35*500*10*85 = 14875000* 10% = 1487500 Rupees

• Before the Expiration date of the contract, though, the trader places an order with the same futures broker to sell 10 July silver futures contracts The order is filled at a price of $33.

• By selling July Silver Futures, the trader has offset the earlier long position and is no longer required to take delivery of the Silver. As the offsetting price is lower than the entry price, the speculator has lost US$2 an ounce, based on the difference between buying and selling prices. As each contract represents 500 troy ounces, the trader has lost 2*500 = $10000. or 850000 rupees

Commodity Forwards & Futures Pricing

Main Factors For Pricing

• The price of a Commodity Forward is based on expectations and there are several factors to consider– Some commodities are storable– Some are appropriate for leasing– In some situations, there is a convenience yield to consider

• Storage costs – Cost to be considered for a buyer of the commodity. They differ for each type of commodity.

• Lease Rate – defined as the amount of return the investor requires to buy and then lend a commodity.

• Convenience Yield – Holding an excess amount of a commodity for a non-monetary benefit. This usually occurs because the owner needs the commodity for their business.

Formulas & Explanations• F0,T = S0 eRFT = This expression says that if there are no costs or benefits associated

with buying and holding the commodity, the forward price is just the spot price compounded at the risk free rate over the holding period.

• If there are benefits (e.g., lease rates, convenience yield) to buying the commodity today, the holder is willing to accpet a lower forward price. The forward price is reduced by the benefit, either the lease rate or convenience yield:– F0,T = S0 e(RF – C)T < S0 eRFT , where c is the convenience yield, or

• F0,T = S0 e(RF – δ)T < S0 eRFT where δ is the lease rate• If there are costs, such as storage costs, associated with purchasing the

commodity today, the forward price is increased by the cost:– F0,T = S0 e(RF + λ)T < S0 eRFT where λ is the storage cost

• If there is a combination of costs and benefits :– F0,T = S0 e(RF + λ - c)T– C = δ+λ

A Typical Example

• Calculate the 3-month forward price for a bag of rice (100 kg) if the current spot rate is 2650 rupees/bag, the effective monthly interest rate is 1% and the monthly storage costs are 1.20 rupees/bag.

• First Calculate the future value (at time T) of storage for 3 months, λ (0,T) as follows:

• 1.2 + 1.2(1.01) +1.2(1.01*1.01) = 3.63 rupees• The amount 3.63 rupees represents three months’ storage

costs plus interest. Next, add the cost of storage to the spot prics plus interest on the spot price:

• F0,T = S0eRFT = 2733.92 rupees

Backwardation• Occurs when the market expects lower forward prices relative to spot prices• Means that the forward curve is downward sloping, it occurs when the lease

rate is greater than the risk-free rate. Based on the commodity forward formula, F0,T S0e(RF-δ1)T ,if (RF-δ1) > 0, then the forward price must be greater than the spot price

• Is the Norm rather than the exception in the crude oil Market• OPEC overproduces when spot prices are high, so market participants know

that when prices rise, they can expect production levels to rise too.• High spot prices MAY lead to exploration and redevelopment of other oil

resources, reinforcing the anticipation of higher supplies in future leading to a lower future price.

• A risk premium or convenience yield is often placed on spot crude oil prices

Candlestick Charting

What are candlestick charts?

• A candlestick chart is a style of bar chart used primarily to describe price movements of a commodity, security, currency or derivative over time.

• It is a combination of a line-chart and a bar-chart, in that each bar represents the range of price movement over a given time interval.

Why Candlestick Charts?• Candlesticks are Easy, powerful and fun to use• Using candlesticks will improve ones analysis of the market• Candlestick techniques can be used for speculation and/or hedging.• The techniques accurately reflects short-term outlooks -- sometimes

lasting less than eight to ten trading sessions • Candlesticks blend perfectly with nearly all of the traders’ common

technical analysis methods, and will increase one’s understanding of any commodity or stock issue as well as provide an incredible insight into the market’s future price moves

• Candlesticks are especially popular because they give investors a very clear visual image of a commodity’s progress

• Candlesticks are known to help investors take advantage of human emotions; they can also use them to get rid of emotionally based weakness in their own portfolios.

Characteristics of Candlesticks • Candlesticks are usually composed of the body (black or white), and

an upper and a lower shadow (wick): the area between the open and the close is called the real body, price excursions above and below the real body are called shadows.

• The wick illustrates the highest and lowest traded prices of a security during the time interval represented.

• The body illustrates the opening and closing trades.• If the security closed higher than it opened, the body is white or

unfilled, with the opening price at the bottom of the body and the closing price at the top. If the security closed lower than it opened, the body is black, with the opening price at the top and the closing price at the bottom.

• A candlestick need not have either a body or a wick.