Last updated on January 18th, 2022 at 06:48 am
In business and trading, one cannot throw free shots around and has to hit the bull’s eye at once unless they want a chunk of losses their way. During World War II, the liberation of Normandy made the end of the bloodshed explicit. Similarly, trading is about investing in places where one is utterly sure about the returns. However, trading without any risks is not always available, but some arbitrage forms can make profits with minimal risks. Such is Commodity Arbitrage, which is a purchase of securities or commodities from one market with the purpose of immediate resale on another market to profit from a price discrepancy and difference. To sum it up, it consists of simultaneous buying and selling of an asset from different platforms to different arenas, exchanges, or locations to cash in on the price difference. While investing in this kind of trade or getting into the same, one has to make sure that the underlying asset that is bought and sold is the same, and only the absolute difference is captured as the net pay-off from arbitrage. Also, the difference should not include execution costs because if not, then initiating the trade would not make much sense after all.
Commodity Arbitrage Strategies
An individual performing such trades must employ well-planned strategies that would enable profits to be made that would align with his risk profile. One of the best ways is technical analysis, a discipline that interprets the market’s movements to profit from trading assets. Prices are systematically observed to comprehend the market. Increases and decreases in prices are not analyzed based on the cause and effect relation, as is done in fundamental analysis, but only for effect. Technical analysts seek to observe some typical situations and financial manner on the market that affect asset quotations and systematically repeat themselves over time, which means analysts presume the existence of trends that are a lagged response of the market prices to the underlying factors governing those prices. In such a way, analysts exploit their expectations on prices to buy or sell assets and make profits. One of the best strategies is to rely on such presumptions, though not always on point, but pretty reliable.
Commodity Arbitrage Example
There is a low, almost no risk arbitrage in MCX Silver throughout the year. MCX listed Silver – 30 Kilos contract size is a necessary delivery contract, and the expiry time difference lies between any two derivative contracts of two months. As per the market’s presumptions, contracts or expands, the spread or difference between two contracts. In the given example, the prices are expected to fall shortly drastically. The spread increases and decreases if the market is optimistically hinting that the traders are willing to pay future premiums immediately as supply shortages. The same leads to an arbitrage opportunity when the spread widens by a good margin. It becomes viable to purchase silver that would result in delivery of near month expiry contract and sell the next month contract, which will expire in the next two months.
Commodity Arbitrage in India
There are plenty of opportunities for commodity arbitrage in India. There is the opportunity for arbitrage on the National Commodities and Derivatives Exchange (NCDEX) and the Multi Commodity Exchange of India (MCX). On January 24, gold contracts maturing for delivery in April ruled at ₹28,815 for 10 gm on NCDEX. On MCX, they were quoted at ₹28,623. In both these transactions, the metal is traded at a unit of 1 kg, with prices being quoted at ₹/10 gm. Here, the arbitrage opportunity is that a trader can buy one unit on MCX and sell one unit on NCDEX. But it is not as simple as it seems because interchanging commodities from MCX to NCDEX or vice versa cannot be done. Thus, a situation where positions are squared off on both the exchanges and the same has to be how prices react simultaneously. Similarly, there are other less systematic options, like wholesale retailers, where people purchase commodities in huge stocks, be it fabrics, clothes, food, etc.
Challenges in Commodity Arbitrage Business
The concept of commodity futures was near death for about four decades and has come alive since the past years when the benefit of the same was observed. That is now replaced with policy, institutional, and market activism. The same has also led to private participation based on market forces because of its liberalization and globalization. This has resulted in increased agricultural produce exposure to lower prices and other market risks, which emphasizes the importance of futures markets for price discovery and price risk management. Gaining profits from commodity trading often requires a combination of market knowledge, luck, and, most importantly, robust risk management. There are significant differences between well-established markets and those struggling to develop, which puts the latter at a disadvantage.
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