Having looked at spread betting shares, what are the strategies available for spread betting commodities? The answer is much the same, whatever the market or the financial instrument we are trading, and that is to use correlation to develop a hedging strategy for the each instrument. In this case we are looking to spread bet commodities, of which the most popular at the moment are gold and oil. With gold breaking out into new high ground over $1200 per ounce, and with oil reaching $170 per barrel last year, both commodities have been in the headlines recently, and as such attracted many new traders to these markets. So let’s take a look at these as our two examples for commodities, and see if we can construct some hedging strategies to allow us to bet with a managed risk profile.
Let’s take gold as our first example and think about related markets that could provide us with a correlation to explore. The first, and perhaps most obvious place to look is in the equities market and in particular at the mining sector where many of the large gold mining companies trade. Assume we begin our analysis by considering the technical position for spot gold on the daily chart, and feel that the precious metal is set to continue its recent bullish trend. An analysis of the commodities sector in general and the underlying fundamentals confirms this view, and we now need to find a correlating market with which to hedge the trade. Having looked at equities in the mining sector our research reveals Barrick Gold Corporation ( ABX ) which appears to correlate positively and very well with the spot gold price, and as such seems to offer a good hedge. As gold and Barrick correlate positively, this means we need to place a buy bet on one and a sell bet on the other. On balance we feel that spot gold should outperform Barrick over time and therefore we are looking to buy gold and sell Barrick Gold. However, this is where the hedge strategy becomes more complex as we are trading two different instruments, with two different profiles, as well as dealing with the issue of how the spread betting companies quote the prices! So where do we start!
First, we have to make sure we are comparing like with like, and by this I mean the underlying units. Most of the spread betting companies quote in 1/100 units for shares and stocks and in 1/10 units for gold. So our bet unit size for our Barrick Gold stock needs to be 10 times that of our spot unit price. The next element we need to factor into our calculation is the relative price movement we can expect in each market in a typical day, and for this we need to study the daily charts and from there, estimate the likely price movement. From this we might find that spot gold typically moves twice as much as the stock price on average, so a $5 per ounce move per day, would have an equivalent move in Barrick of around $2.50 per day. Whilst this can only ever be our best estimate, we do have to base our analysis on this type of assessment in order to cross hedge between different markets and instruments. As a result, and based on the following we would factor our spot gold unit price using a multiplier of 5 ( 10 / 2) in order to set up our balanced hedging position. So in the above example if we take £1 as our minimum bet per 1 cent movement in the share price and buy Barrick Gold, then our balancing position in spot Gold would be £5 per 10 cents. Not a simple trade to set up, but well worth the time and effort and although a little more complex an excellent way to hedge your risk when trading in commodities.
There are of course many other ways to hedge commodities such as gold, and other examples would be against the US dollar where the correlation tends to be inverse, and against silver ( an industrial metal not a precious one as many believe) which in this case is positive. There are of course many other mining stocks in both the UK, US, Canadian and Australian markets against which to hedge.
The other commodity which is very popular is of course crude oil, and the most popular hedge trading strategy here is to hedge between the various different contracts available quoted by the spread betting companies. The two most popular are US light sweet crude which follows the WTI West Texas Intermediate futures price, and Brent Crude which accounts for almost 70% of the oil contracts traded every day. Setting up a hedge position for crude oil is very straightforward using the two oil markets as we are comparing two similar markets which are also quoted at the same unit price, which for most spread betting companies is for each 1 cent price movement in a barrel of oil. The minimum bet size is usually £1 although some spread bets start at £2 per 1 cent. Our hedging position here is once again based on two markets which correlate positively, so in this case we would trade long on one contract and short on the other and as the prices are likely to be relatively close to one another we would use the same bet amount on each in this example. So with oil trading at $70 per barrel then we would go long on one contract at £1 and similarly short on the other at the same unit price of £1. Typically the two contracts trade within an average of a $3 per barrel difference in price, and in order to make money with this hedge you will probably need to weight one trade in respect to another in order to profit from the price differential between the two contracts. An alternative hedge rather than in two oil contracts is to hedge the WTI oil contract with a currency pair such as the CAD/JPY which tends to track oil closely and correlates positively. There are ofcourse many others to look at but these are just a few.
So having looked at strategies for both shares and commodities, now let’s look at one of the biggest markets – forex!