Commodity Volatility Leads to Fortunes Made and Lost
By nature, when we think of large price moves in leveraged markets, we assume that there are riches to be made. However, this isn’t necessarily the case; traders must be on the right side of the trade to make money, and that is easier said than done. Even worse than missing a big price move is being caught on the wrong side of it. The media’s (and politicians’) arguments against “greedy” speculators seem to imply that a majority of traders make money and that it is somehow easy to do so. This couldn’t be further from the truth; if it were, wouldn’t they be doing it, too? Profitable trading is possible for those who are dedicated and capable of controlling their emotions, but it is far from being a sure-fire way for the “rich to get richer,” as many assume.
Because of its profound impact on the economy and our daily lives, crude oil futures are often at the center of the debate. Believe me, not all speculators in the energy complex make money. Crude oil is one of the most challenging markets to trade successfully, regardless of whether you are a futures or options trader. The margin requirement is extremely high, and so are the volatility and risk. Figure I.3 portrays the magnitude of risk and reward energy traders might face.
Figure I.3. Crude oil traders have the potential for large gains, but the risk is of equal magnitude. Not many could have predicted that crude oil would rally to $150 per barrel, only to collapse to less than $40. Such a move represents more than $100,000 per contract.
(Chart courtesy of QST.)
Surprisingly, based on my experience and conversations with those within the futures and options industry, the 2007 commodity rally was paralyzing for many veteran traders but was a likely gold mine for investors who simply didn’t know that wheat shouldn’t trade in double digits, nor crude oil in mid-$150s. For investors who had been trading grains for many years, it was not only unimaginable, but in some cases, career ending.
Traders who spent the bulk of their adulthood speculating on grain and energy prices as they moved from high to low within their historical price envelopes quickly discovered that the markets no longer had boundaries. For example, before 2007, wheat was a commodity that was most comfortable trading between $2.00 and $4.00 per bushel, with a few brief stints in the $6.00 range. Looking at a long-term wheat chart, it is easy to see how a trader could unexpectedly get caught on the wrong side of a move that eventually got close to doubling the previous all-time high of the commodity. Those who did find themselves in such positions were in a state of denial and had a difficult time liquidating positions with large losses. As a result, the situation became worse as losses mounted, as did margin calls (see Figure I.4).
Figure I.4. Few could have predicted the magnitude of the 2007—2008 wheat rally that made a mockery of its previous all-time high.
(Chart courtesy of QST.)
You might have heard about the rogue (unauthorized and reckless) wheat trader whose actions during the historic wheat rally resulted in a large loss at a major financial institution. Without permission from his brokerage firm, MF Global, the trader greatly exceeded his trading limits due to a loophole in the trading platforms. The culprit was a commodity broker located in Memphis, Tennessee, who reportedly put his account—and, ultimately, MF Global—in the hole more than $141 million. This is believed to be the largest unauthorized loss in the history of the agricultural markets. Ironically, MF Global survived the debacle despite its stock immediately losing nearly a third of its value but claimed bankruptcy a few years later due to large losses in trades authorized by its own CEO, Jon Corzine. We’ll discuss this next.
Prior to the unauthorized wheat trade, the MF Global broker triggering the debacle had been a responsibly registered participant of the futures industry for more than 15 years; perhaps in this case, his experience worked against him, in that he was overly bearish in a market that simply wasn’t “playing by the rules.”
Keep in mind that, in the precommodity boom world, the margin to hold a wheat futures position overnight was less than $1,000. During its heyday, it was in the neighborhood of several thousand dollars. Therein lies much of the problem: As commodities become more volatile, they also become more expensive to hold. In such an environment, traders are forced to fold their hands due to a lack of margin or liquidity. The liquidation of short positions adds to the buying pressure of speculative long plays, and prices can quickly become astronomical.