The most successful commodity traders understand the secret strategies. The commodity trading arena is quite different from stock trading.
Here are the 5 commodity trading strategies that the top traders use:
- Geographic arbitrage
- Time arbitrage
- Quality arbitrage
- Trade execution
Strategy #1: Geographic Arbitrage
It’s the most common one and it’s really how commodity trading started. Let’s say: one day, a farmer got tired of being a farmer and got the information that in the village after the mountains, a bushel of wheat cost 3 silver coins while the same bushel costs 5 silver coins in his village.
Instead of thinking like all his other farmer friends, that they absolutely have to sell their wheat at a higher price in their village, he got a different idea. He borrowed as much money as possible, rented a chariot to transport the wheat, and hired a couple of mercenaries.
The farmer went to the village after the Mountains and purchased a bushel of wheat for 3 silver coins. Then, returned to his village and sold the same bushel of wheat for 5 silver coins. Once he’d spent 1 silver coin for the cost of financing, transporting, and security, he had one coin left as a profit.
Over time, if he carries on with this trade or if other people copy him, then we may see the price of wheat in the village after the mountain will increase to 4 silver coins because of the new demand pressure. Consequently, we would see the price of wheat in his village decrease to four silver coins because there’s enough supply. Then, the geographic arbitrage opportunity disappears. Currently, this is still exactly what is going on.
Recently Japan was hit by a really strong cold wave. Locally, the price of gas went up. Then all the traders shipped the gas there and then it went down exactly like the farmer’s case.
Strategy #2: Time Arbitrage
When your cost of storing a commodity or so-called cost of carrying is cheaper than what the market is ready to pay, you can make money on the difference.
If your cost of carrying is cheaper than what the market is willing to pay. You can buy a commodity today at a spot price and sell it today for future delivery and still make money. Here’s a link to a video where I explain further a strategy called cash and carry arbitrage; which is basically the same as time arbitrage. It’s just a different name.
Strategy #3: Quality Arbitrage
The big idea behind this strategy is that commodity is not as interchangeable or as fungible as it may seem. Therefore, traders will find a way to use this quality difference to their advantage.
For instance, let’s say that a trader bought a high-quality fuel with a low level of toxicity. His client doesn’t think of quality as low in terms of toxicity. Then the trader may blend this high-quality fuel with a dirty, cheap, low-quality, high-level-of-toxicity fuel just to meet perfectly the client’s requirement.
With almost all commodities, you can do some kind of blending or light processing to increase your margin.
Strategy #4: Trade execution
The more cost-efficiently a company can transport and finance a commodity from place A to place B, the more money they are going to make.
Trade execution is a strategy because at the end of the day, as a trader you need to deliver your cargo to your customer. In what way is this a strategy per se? This is a fair question but you need to understand that logistics is a messy and hard business. There is always a new program that you need to tackle: strike bad weather, piracy, miscommunication, your truck driver got arrested by the police, and so on. It’s an endless stream of problems.
So, some companies decided to make everything in their power to have a flawless execution. They pay well their operators, and they have tight processes, but their operators can break them if needed. They keep their employees educated, and up to date.
Other companies, on the other hand, barely care. They localize their operation to another time zone for cheap and untrained workers. Needless to say, they pay for operational mistakes.
Strategy #6: Speculation
Commodity traders often speculate. Speculation in this case means they take a directional bet on where the market is going. They are a thousand ways to speculate. However, at the end of the day, it’s always a matter of betting if the market is going up or going down. It’s not more complicated than that.
The level of speculation will completely depend on the market (commodity + region for example Diesel + the Mediterranean) they are in.
In some markets, it’s so competitive that you have to take position (speculate) to actively participate. As a rough estimation, 80% of the companies speculate on 20% of their book. Then, 20% of the companies speculate on 80% of their book. It really depends on the market they are in and their business.