TradingKey - Since the threat of tariffs from Trump, commodity prices have repeatedly reached new highs. On March 31, 2025, the price of gold exceeded its previous all-time high of $3,100. As of the week ending March 19, 2024, asset management institutions like hedge funds increased their long positions in six types of oil-linked futures options contracts equivalent to 140 million barrels of oil. This large-scale increase in long positions for crude oil futures options set a record for the largest single-week purchase since December 2010. In this uncertain international environment, options and futures emerge as crucial risk management tools in commodity trading. So how can one skillfully employ advanced trading strategies such as hedging, managing risks with futures options, and speculating based on market trends in commodity trading? This article will provide answers to these questions one by one.

What is Hedging?

Hedging is simultaneously entering two correlated, oppositely directed trades, and of equal quantity, aimed at reducing investment risk. In commodity investing, where prices are subject to complex influences such as global economic and political factors, volatility is frequent and substantial, making hedging strategies crucial. The core principle involves utilizing the correlation of asset prices to construct opposing positions, allowing losses on one side to be offset by gains on the other, thus mitigating price fluctuation risks and achieving relative asset stability.

Common Hedging Methods

Hedging with Futures Contracts

Investors can lock in future prices by buying or selling futures contracts that correspond to the underlying spot commodities.

• Hedging

Hedging is a common risk management strategy employed by commodity producers, processors, and traders. Based on their forecasts of future prices, they use futures contracts to mitigate the risk of price volatility. If they anticipate a decline in commodity prices, companies holding the physical commodity will sell an equivalent amount of futures contracts in the market. When spot prices fall, gains from the futures market can help balance out losses incurred in the spot market. Conversely, if companies are concerned about rising future prices, they will buy futures contracts to secure their procurement costs.

Take an oil company as an example. The company anticipates that the price of crude oil will decline, which may affect its sales revenue. To mitigate the risk, the company sold crude oil futures contracts for delivery in six months for $71 per barrel in the futures market, while the spot price at that time was $68 per barrel. Six months later, the spot price dropped to $62 per barrel, and the futures price fell to $65 per barrel. Although sales revenue in the spot market decreased, the company was able to make a profit in the futures market because the selling price exceeded the buying price for closing its positions, thus partially offsetting losses in the spot market.

• Basis Trading

The basis refers to the difference between spot prices and futures prices; its changing trend provides hedging opportunities. When the basis strengthens, it is particularly advantageous for those executing sell hedges. This occurs when the increase in spot prices is greater than that of futures prices, or when the decrease in spot prices is smaller than that of futures prices, allowing for more effective risk management through selling hedges.

• Inter-Period Arbitrage

Price differences can exist between futures contracts of the same commodity with different delivery months. When such price spreads deviate from their normal range, inter-period arbitrage opportunities arise. If the price of a near-month contract is excessively high compared to a far-month contract, investors can sell the near-month contract while buying the far-month contract. Once the price spread returns to normal, they can close their positions for a profit. This strategy not only helps mitigate risks associated with fluctuations in a single contract’s price but also allows for relatively stable returns.

Options Hedging

Options hedging offers greater flexibility. Investors can purchase call or put options to safeguard themselves against adverse price movements.

• Buying Protective Put Options

If an investor holds a long position in a physical commodity or futures contract and is concerned about potential losses from price declines, they can choose to buy put options for protection. When prices fall, the profits from the put options can offset losses on the physical or futures positions, providing a protective cushion. If prices rise instead, the investor only incurs the cost of the option premium while still benefiting from any gains associated with the price increase.

Take an agricultural products producer as an example. The producer is worried that a future decline in the price of agricultural products will affect its sales revenue, so it purchases a put option. Suppose the current spot price of soybeans is 4,000 yuan per ton. The producer buys a put option on soybeans with a strike price of 3,900 yuan per ton and pays a premium of 100 yuan per ton. If the price of soybeans falls to 3,700 yuan per ton in the future, the producer can exercise the put option and sell the soybeans at 3,900 yuan per ton.

• Selling Covered Call Options

For investors holding spot commodities and expecting no significant price increase in the short term, selling call options can generate premium income, thereby enhancing investment returns. If the price does not reach the strike price, the options are not exercised, allowing the investor to secure the premium. If prices exceed the strike price, the investor must sell the spot commodity at that price, yet the premium received partially offsets the opportunity cost of the price increase.

• Utilizing Options Combination Strategies

By constructing various combinations of options, such as butterfly spreads or iron condor strategies, investors can flexibly adjust their risk-return profiles according to market expectations and risk tolerance. A butterfly spread involves buying a lower strike call option, selling two middle strike call options, and buying a higher strike call option. This strategy is suitable for situations where price volatility is expected to be low, allowing the investor to achieve limited profits within a specific price range while managing risks effectively.

Cross-Commodity Hedging

Cross-commodity hedging is based on the price correlations between different commodities. Some commodities exhibit upstream or downstream relationships in the supply chain, or they share substitute uses, leading to similar price movement trends. For instance, corn and soybeans can act as substitutes in feed production, displaying a degree of price correlation under certain conditions. When investors forecast that the price increase in soybeans may be smaller than that in corn, they might buy corn futures while selling soybean futures. If the market moves as expected, profits from corn futures can offset losses in soybean futures, achieving the intended hedging effect.

Time Diversification Hedging

Time diversification hedging involves spreading investments across different periods based on the price fluctuation characteristics of the commodities. For example, suppose an investor is optimistic about gold's future price increase but is concerned about short-term volatility. In that case, they can buy futures contracts with varying expiration dates, such as near-month, next-month, and contracts expiring in three months. This approach ensures that even if one contract experiences short-term losses due to price fluctuations, other contracts may still yield profits, thus reducing overall risk through temporal diversification.

Evaluating Hedging Effectiveness

Hedging Ratio Assessment

The hedging ratio is a key metric for measuring the proportion of hedged positions relative to spot positions, ideally targeting a perfect 1:1 hedge. However, achieving this exact ratio can be challenging in practice due to the complexities and variability of market conditions. For example, in futures contract hedging, if an investor holds 100 tons in spot commodities, but the corresponding futures contracts cover only 95 tons, the hedging ratio is 0.95, indicating a deviation from the ideal situation, which may impact the effectiveness of the hedge.

Effectiveness Analysis

The effectiveness of hedging strategies can be assessed by comparing price volatility before and after the implementation of hedging. Statistical methods can be employed to calculate the standard deviation of portfolio returns before and after hedging. A smaller standard deviation indicates reduced price volatility and, thus, a more significant hedging effect. For instance, if a portfolio's standard deviation of returns before hedging is 15%, and it drops to 8% after applying the hedging strategy, this demonstrates that the hedging strategy effectively minimized price volatility risks, thereby enhancing portfolio stability.

Cost-Benefit Considerations

When evaluating hedging strategies, it is also necessary to consider the relationship between their costs and expected returns. If the cost savings resulting from the risk reduction brought about by hedging exceed the expenses of the hedging operation, then the hedging can be considered effective. Take the futures hedging operation of a certain enterprise as an example. The company incurred transaction handling fees and margin costs amounting to 100,000 yuan. However, through effective hedging, it successfully prevented an increase in expenses by 500,000 yuan that would have resulted from a substantial rise in raw material prices. The benefits of the hedging strategy far outweigh the costs, making it worthwhile to implement.

Assessment of Remaining Risk Exposure

Finally, it is essential to evaluate the remaining risk exposure after hedging to ensure it remains within acceptable limits. Remaining risk exposure refers to the portion of risk that is not protected by hedging. By conducting a thorough analysis and calculation of market risk factors, companies can determine the magnitude of their remaining risk exposure. For example, in currency hedging, businesses must carefully assess any residual exchange rate risk; if the exposure remains excessive, they may continue to face significant currency volatility risks, prompting the need for adjustments to their hedging strategies to further mitigate risk.

Trend-Following Strategy

Trend-based speculative strategies are essential tools for investors seeking profits in the commodity markets, with trend-following being one of the most fundamental and widely used approaches. The core of this strategy lies in identifying and following the primary market trends by buying in an uptrend and selling in a downtrend to generate returns.

To effectively implement a trend-following strategy, technical analysis tools are needed to determine the direction of market trends. By studying historical price and volume data and employing various technical indicators and chart patterns, investors can forecast future price movements. Common technical analysis tools include moving averages, the Relative Strength Index (RSI), and Bollinger Bands. For instance, when a short-term moving average crosses above a long-term moving average, it creates a "golden cross," signaling a buy opportunity as it suggests potential price increases. Conversely, when it crosses below, forming a "death cross," it indicates a sell signal, hinting at possible price declines. The RSI measures the strength of buying and selling pressures on a scale of 0 to 100, with levels above 70 indicating overbought conditions (potential price pullback) and levels below 30 indicating oversold conditions (potential price rebound).

Fundamental Analysis Strategy

This approach involves a thorough analysis of fundamental factors impacting commodity prices, such as supply and demand dynamics, macroeconomic indicators, and policy changes to forecast price movements and make informed investment decisions. For example, during periods of robust global economic growth, demand for metals like steel and copper tends to rise, often leading to price increases for these commodities.

Event-Driven Strategy

Event-driven strategies involve speculating based on the impact of specific events on commodity prices. Many occurrences can trigger significant price fluctuations in the commodity markets, including natural disasters, policy announcements, and major economic data releases.

For instance, droughts, floods, and hurricanes can directly affect crop growth and yields. In 2023, Brazil faced severe drought conditions, significantly reducing the output of coffee, soybeans, and other agricultural products. As coffee is a critical global commodity, the decrease in supply sparked market concerns, leading to substantial increases in coffee futures prices. Investors who anticipated the drought situation in Brazil and purchased coffee futures contracts before the price surge could realize profits during the price increase.