Commodity investments can provide a suitable diversification for investors. There are a variety of day-to-day products available in commodity markets. Investors get exposure to their daily commodity needs through these markets.
Commodity derivatives are contractual transactions for such investments. As of September 2024, the key commodity index, MCX iCOMDEX Composite, has increased by nearly 7.5% since the start of FY 2024-25. This rally has been a rollercoaster, with a rise up to May 2024 and a fall since then. However, the market projections for FY 2024-25 are strong, with nearly 9.8% growth.
In such mixed market conditions, trading commodity derivatives can be difficult. Strategies like arbitrage can benefit the traders in such markets. However, the primary question for traders is how to find arbitrage opportunities in the commodity markets.
Let’s explore strategies to find arbitrage opportunities and their implications or risks.
What are arbitrage opportunities?
The commodities have complex procedures from procurement, storage, transportation to sale. In this process, the prices of these commodities can vary based on commodity market or contracts. For example, in futures contracts the spot price can be different from expiry price.
During this mispricing or fluctuation, traders may not find a definite projection of future prices. Therefore, they can enter two or more positions with varying natures in multiple markets. Further, they may gain from their sale or buy position based on price movement. It is known as arbitrage trading.
Must read: Getting started with commodity trading instruments: The beginner’s playbook
Usually, investors willing to secure their capital opt for arbitrage trading with low risk. Moreover, it also helps them sometimes to gain from fluctuating markets. However, more than trading, finding the appropriate arbitrage opportunity is crucial. There are several opportunities which can be used for arbitrage trading.
Types of commodity markets arbitrage opportunities
- Spatial: The difference between the prices of the same asset on different markets or positions is known as spread. When a trader gauges this spread in different geographical markets, it is known as spatial arbitrage.
- Triangular: In this, three different commodities, with a lack of correlation, are selected. Traders take buy and sale positions in these commodities in different markets. The mispricing of these commodities helps gain profit in different positions. However, the trader should have a proper understanding of the relationship between these commodities.
- Temporal: It is a common technique for profiting from short-term price discrepancies. However, in this type, the asset is the same, and the trader bets on future price action. A person may buy an asset at a lower price with an anticipation to sell it at a higher price.
- Inter-market or inter-commodity: This transaction may happen in different markets, such as the commodity market and stock market, simultaneously. Moreover, in inter-commodity, the positions may be taken in two or more commodities with low correlation.
- Calendar spread: In this type, the traders take a position in future contracts and gauge the price discrepancy in the spot and expiry period. It is also known as the time-decaying technique. Usually, the expiry of the contract is expected to be near-dated.
- Statistical: It has an intensive approach that includes the application of various statistical methods, like correlation, regression, mean deviation, etc. In this, traders have diversified portfolios to spread the price difference and use it for statistical application.
An interesting read: Here is all you need to know about commodity futures
How to find arbitrage opportunities in commodity markets?
Executing an arbitrage trade may be simpler than finding suitable arbitrage opportunities. Here are some techniques to find the appropriate arbitrage opportunity in the market.
- Price discrepancy
Traders need to monitor the market to spot price fluctuations or mispricing in different markets. Moreover, the spread of deviating prices should be evaluated with respect to the average price. The same asset on different markets may be selected to check the deviations.
The sideways movement of the prices may provide the support and resistance levels for a particular stock. Further, a trader should gauge the potential price and position the trade based on it. Also, historical price movements and indicators can be used.
Some statistical tools such as central tendency, correlation, regression or standard deviation can be used to measure accurate spread potential. Usually, the commodities with low correlation are selected to benefit from both- buy and sell positions.
These days, traders use algorithmic trading and machine learning techniques to enter and exit the market frequently. HFT is a powerful programme that taps every distinct price and executes multiple trades in a short period.
Also, read The Complete Guide to Algo Trading: Strategies and Potential Pitfalls
Risks and challenges of commodity arbitrage
Along with lucrative returns that can be earned with any market movement, arbitrage opportunities are also accompanied by some risks.
- The commodity markets are inherently volatile as they are directly linked with consumption.
- Arbitrage opportunities may be short-lived, and missing the desired exit levels can cost the traders.
- Dealing on multiple exchanges or markets may cost investors high transaction or brokerage costs. Therefore, investors should determine the level of cost that can be incurred from the profits.
- Commodity arbitrage is a prominent strategy used by many investors in the market. It makes the trades competitive.
Summary
Arbitrage trading in commodity markets with the help of derivatives or regular commodities can be a unique option for diversification. However, the execution of trade is preceded by finding suitable arbitrage opportunities. Traders can use different techniques for the same.
FAQs
- What are arbitrage bets?
An event may have multiple outcomes, and their likeliness of happening may confuse the investors. In such a scenario, an investor may place bets on these multiple outcomes simultaneously and gain from them. For example, a share price may break out, stagnate or fall. If a trader bets on all three situations in different markets, it is an arbitrage bet.
- What is asset spread for arbitrage?
The price difference of a commodity in different markets is known as asset spread. It provides a crucial base for arbitrage trading. Investors need to analyse this spread to base their positions in different markets. Moreover, entry and exit may also depend on this potential spread.
- What are the components traded on the commodity markets?
Several raw materials and their derivatives are traded on the commodity markets. Agricultural products like wheat, corn, soybean, etc., are some of the common products. The non-agricultural products like metals, oil and other materials derive energy.
- What is spatial arbitrage?
It is one of the most known arbitrage strategies. In this, investors would buy an asset at a cheaper price in one market and simultaneously, sell a similar asset in the other market where it has a higher price. The difference between these two trades results in gains for the investors.
- What statistical tools are used for finding arbitrage opportunities?
Arbitrage opportunity occurs when the assets are mispriced in different markets. Therefore, to gauge this mispricing, investors can use different statistical tools such as correlation analysis, regression, time series analysis, etc. It helps them find the potential spread in the market and position accordingly.
