Commodities As Risk Transfer Markets

I jotted a few notes from this terrific conversation between Eric Crittenden of Standpoint and my friend Jason Buck of Mutiny.

If you read CTA (especially trend-following CTAs) decks about why trend-following works in commodities you will hear stories that sound like:

• taking the other side of hedgers
• markets have behavioral biases like anchoring which cause futures to underreact on breakouts

These are reasonable claims. I traded commodity options for most of my career and a lot of flow is in fact constrained (ie forced and price-insensitive) due to hedging covenants attached to financing arrangements for new projects such as plants and wells. The behavioral bias argument sounds good but I’m not sure to what extent biases like that cancel out (just replace “extrapolators” for “greed” and “mean-reversioners” for “fear”).

Overall, I think commodity markets are basically zero-sum. They make sense as diversifers because they can act as an inflation hedge at times. But because inflation is diabolically hard to hedge in isolation, I’d expect futures markets to have negative expected returns after fees and taxes (note the similarity to insurance. It’s negative expected return but still makes sense as a diversified and hedge when you consider compounded returns at the portfolio level). The pre-fee/tax return is probably random depending on the term-structure.

Yet, Eric and Jason’s discussion framed the problem in a way I hadn’t thought of which is more of a risk transfer service. Since the demand to transfer risk is not static the curve shapes and positioning will be key determinants of which way the edge presents itself.

If CTA positioning is inversely correlated with physical hedger positions you’d expect positive edge. I found this provocative because one of the trades I liked to look for was actually betting against the CTAs but in an asymmetrical way. If CTA’s were all-out long coffee futures (for example the Commitment of Trader’s Report, aka COT, showed that as a percentage of open interest managed money length was in the 100th percentile) then I’d like to look for cheap put skew to buy. My reasoning was that CTAs are actually weak hands in the sense that they just follow price, so if there was a sharp reversal in the market they’d rush for the exits together. CTAs often use similar signals (breakouts or moving averages for entries and stops for exits) so they tend to have correlated flows.

Now, percentiles are risky inputs to trades. If something is in the 100th percentile today and goes up tomorrow that is the new 100th percentile. But I was betting in a risk-contrained way. Instead of shorting, I was buying puts (and again only if the skew surface presented attractive pricing…the qualitative and quantitative both need to line up, and even then an idea like this is a small edge and small part of a broader portfolio).

Here is a pertinent excerpt from the interview (bold is mine):

Jason Buck: You said three return sources, so eliminate the three return sources that you believe you have?

Eric Crittenden: So, I feel like there’s capital formation markets, like stocks and bonds, which are kind of a one-way street, the risk premia is kind of a one-way street. I mean, the bulk of the risk premia is your long stocks. The futures, whether it’s metals, grains, livestock, energy, these are risk transfer markets and risk transfer markets are different than capital formation markets. I feel like risk transfer markets, you need to be symmetrical, you need to be willing to go long or short, because they’re a zero-sum game. They have term structures, so they’re factoring expectations, storage costs, cost of carry, all that stuff. And then there’s the risk-free rate of return, which used to be a great way to kind of recapture inflation, it’s not so much anymore.

[Eric continues…]

This is an important concept to me, because it goes to the point of why I do what I do, or why I think that macro trend-oriented approaches expect a positive return over time, because the futures markets are a zero-sum game or actually, a negative-sum game after you pay the brokers, and the NFA fees, and all that stuff. So, in a negative-sum game, you better have a reason for participating. For you to expect to make money, you better be adding something to that ecosystem that someone else is willing to pay for, because somebody else has to mathematically lose money in order for you to make money. So, in studying the futures markets, and I’ve been on both sides, I’ve been on the corporate hedging side, I’ve been on the professional futures trader side.

I believe I understand who that somebody is, that has deep pockets, and they’re both willing and able to lose money on their future’s position. A trend-oriented philosophy that’s liquidity weighted is going to be trading opposite those people on a dollar-weighted basis through time. It does make sense that they would lose money on their hedge positions, I mean, in what world would it make sense for people who hedge, which is the same thing as buying insurance, to make money from that? It makes no sense, that would be an inverted, illogical world. So, anyone who’s providing liquidity to them should expect some form of a risk premia to flow to them. It’s just up to you to manage your risk, to survive the path traveled, and that’s what trend following is. I don’t know why that is so controversial, and more people don’t talk about it, because I couldn’t sleep at night if I didn’t truly believe that what we’re doing deserves the returns that we’re getting.

Jason Buck: CTA trend followers, or whatever, just they don’t really know how they make money. They’re like, “It’s trending, it’s behavioral, it’s clustering, it’s herd mentality, and that’s how we make money.” You’ve accurately portrayed it as these are risk-transfer services, speculators make money off of corporate hedgers. But the only thing I would push back, and I’m curious your take on this, is like you said, zero-sum game or negative-sum at the individual trade level. But when we look more holistically, those corporate hedgers are hedging their position for a reason, and it’s likely lowering their cost of capital for one of the exogenous effects. So, my question always is, is it really zero-sum or negative-sum, or is it positive-sum kind of all the way around? In a sense that the speculator can make money offering these risk transfer services that the hedgers are looking for that liquidity, and then the hedgers are also… If we look at the rest of their business, they’re hedging out a lot of their risks, which can actually improve their business over time, whether that’s cost of capital, structure, or other exogenous effects.

Eric Crittenden: Absolutely, I wish I had… You did record this, so I’m going to steal everything you just said. In the future’s market, it’s negative-sum. If you include the 50% of participants that are commercial hedgers, it’s no longer zero-sum. But most CTAs, and futures traders, and futures investors don’t even concern themselves with what’s going on outside the futures market. So, but if you pull that in and look at it, you can see, or at least it’s clear to me, we’re providing liquidity to these hedgers. They’re losing some money to us, and the more money they lose to us, the better off their business is doing, for a variety of reasons. Tighter cash flows, more predictable cash flows results in a higher stock price, typically. But you brought one up that almost no one ever talks about, and that is if they’re hedged, their cost of capital, the interest rate that they have to pay investors on their bonds is considerably lower. Oftentimes, they end up saving more money on their financing than they lose on their hedging, and they protect the business, and they make Wall Street happy at the same time, so who’s really the premium payer in that? It’s their lenders. So, by being a macro trend follower in the future space, the actual source of your profits is some bank that’s lending money to corporations that are hedging these futures. So, it’s the third and fourth order of thinking, and you can never prove any of this, which is great, because if you could prove it, then everyone would do it, and then the margins would get squeezed.

• I created a Twitter list to follow commodities folk. I’ll add to it as I learn of more accounts that fit. (Twitter list)
• The CME has a great tool for charting and studying the CFTC’s COT report. You will need to sign up for their free QuikStrike suite of analytics.