Risk Control Methods in Commodity Futures Trading
One of the important elements of commodity futures trading is to have the discipline to exit losing trades. Many novice traders have fallen into the trap of holding on to their positions for too long whilst in a trade, hopefully anticipating for a turn in market trend. However, this does not happen and they end up spiraling deeper and deeper into greater losses. At the end of it all, they have no choice but to exit the market with a huge portion of their capital wiped out.
This would not have occurred if they had implemented risk control strategies typical of experienced commodity futures traders. Appropriate stop losses are calculated and put into place at the point when they enter a trade. Evidently, stop losses are part of a trading plan which includes profit targets, and stop loss adjustments. Once a stop loss is hit, traders exit their trades with minimal or acceptable losses, and subsequently move on to the next trade. This goes to show that an experienced trader is well aware of his risk tolerance levels when he enters a trade. He also understands that not all of his trades will turn out favorably, and that there is a probability for winning and losing each time.
Subsequently, the next question now would be, how would a trader identify the right stop losses to place? According to Bruce Kovner, an experienced trader featured in the book Market Wizards, he would utilize technical analysis methods to pinpoint technical barriers which are great locations to place stops. However, he cautions against placing stops within a trading range in ranging markets, as this will result in being stopped out prematurely. Thus, he advocates placing stop losses beyond the trading range while trading in
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chart.
Another aspect of commodity futures trading would be the maximum percentage of capital that a trader should risk in each trade. The general contention is that a trader should not risk more than 5% of his capital in each of his trades. In fact, 1% to 2%
would be preferable risk levels for each trade. Any percentage higher than this will result in relatively huge losses should a trade go wrong. In these circumstances, a trader could get wiped out in no time if he is on a losing streak. Thus, with a lower risk level, a trader would still have adequate capital to make a comeback should his trades turn out to be losses.
Finally, any commodity futures trader should analyze his past losses to determine the causes of failure. This way, he is able to learn from his mistakes and avoid making them again. At times, traders who have been suffering from a losing streak should take a break from trading in order regain their emotional stance before going into the market again.
Risk Analysis Methodology
I) Monte Carlo methods (or Monte Carlo experiments) are a class of computational algorithms that rely on repeated random sampling to compute their results. Monte Carlo methods are often used in simulating physical and mathematical systems. Because of their reliance on repeated computation of random or pseudo-random numbers, these methods are most suited to calculation by a computer and tend to be used when it is unfeasible or impossible to compute an exact result with a deterministic algorithm.
Monte Carlo simulation methods are especially useful in studying systems with a large number of coupled degrees of freedom, such as fluids, disordered materials, strongly coupled solids, and cellular structures (see cellular Potts model). More broadly, Monte Carlo methods are useful for modeling phenomena with significant uncertainty in inputs, such as the calculation of risk in business. These methods are also widely used in mathematics: a classic use is for the evaluation of definite integrals, particularly multidimensional integrals with complicated boundary conditions. It is a widely successful method in risk analysis when compared with alternative methods or human intuition. When Monte Carlo simulations have been applied in space exploration and oil exploration, actual observations of failures, cost overruns and schedule overruns are routinely better predicted by the simulations than by human intuition or alternative "soft" methods
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II) Value at Risk (VaR) is a widely used risk measure of the risk of loss on a specific portfolio of financial assets. For a given portfolio, probability and time horizon, VaR is defined as a threshold value such that the probability that the mark-to-market loss on the portfolio over the given time horizon exceeds this value (assuming normal markets and no trading in the portfolio) is the given probability level
For example, if a portfolio of stocks has a one-day 5% VaR of $1 million, there is a 0.05 probability that the portfolio will fall in value by more than $1 million over a one day period, assuming markets are normal and there is no trading. Informally, a loss of $1 million or more on this portfolio is expected on 1 day in 20. A loss which exceeds the VaR threshold is termed a “VaR break.”
The 5% Value at Risk of a hypothetical profit-and-loss probability density function VaR has five main uses in finance: risk management, risk measurement, financial control, financial reporting and computing regulatory capital. VaR is sometimes used in non-financial applications as well.
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III) The internal rate of return (IRR) is a rate of return used in capital budgeting to measure and compare the profitability of investments. It is also called the discounted cash flow rate of return (DCFROR) or simply the rate of return (ROR). In the context of savings and loans the IRR is also called the effective interest rate. The term internal refers to the fact that its calculation does not incorporate environmental factors (e.g., the interest rate or inflation).
Uses
Because the internal rate of return is a rate quantity, it is an indicator of the efficiency, quality, or yield of an investment. This is in contrast with the net present value, which is an indicator of the value or magnitude of an investment.
An investment is considered acceptable if its internal rate of return is greater than an established minimum acceptable rate of return or cost of capital. In a scenario where an investment is considered by a firm that has equity holders, this minimum rate is the cost of capital of the investment (which may be determined by the risk-adjusted cost of capital of alternative investments). This ensures that the
investment is supported by equity holders since, in general, an investment whose IRR exceeds its cost of capital adds value for the company (i.e., it is economically profitable).
Calculation
Given a collection of pairs (time, cash flow) involved in a project, the internal rate of return follows from the net present value as a function of the rate of return. A rate of return for which this function is zero is an internal rate of return.
Given the (period, cash flow) pairs (n, Cn) where n is a positive integer, the total number of periods N, and the net present value NPV, the internal rate of return is given by r in:
Note that the period is usually given in years, but the calculation may be made simpler if r is calculated using the period in which the majority of the problem is defined (e.g., using months if most of the cash flows occur at monthly intervals) and converted to a yearly period thereafter.
Note that any fixed time can be used in place of the present (e.g., the end of one interval of an annuity); the value obtained is zero if and only if the NPV is zero.
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In the case that the cash flows are random variables, such as in the case of a life annuity, the expected values are put into the above formula.
Often, the value of r cannot be found analytically. In this case, numerical methods or graphical methods must be used.
Example
If an investment may be given by the sequence of cash flows Then the IRR r is given by
. In this case, the answer is 14.3%.
IV) Net Present Value (NPV) or net present worth (NPW) of a time series of cash flows, both incoming and outgoing, is defined as the sum of the present values (PVs) of the individual cash flows. In the case when all future cash flows are incoming (such as coupons and principal of a bond) and the only outflow of cash is the purchase price, the NPV is simply the PV of future cash flows minus the purchase price (which is its own PV).
NPV is a central tool in discounted cash flow (DCF) analysis, and is a standard method for using the time value of money to appraise long-term projects. Used for capital budgeting, and widely throughout economics, finance, and accounting, it measures the excess or shortfall of cash flows, in present value terms, once financing charges are met.
Year (n) Cash Flow (Cn)
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Formula
Each cash inflow/outflow is discounted back to its present value (PV). Then they are summed. Therefore NPV is the sum of all terms,
where
t - the time of the cash flow
i - the discount rate (the rate of return that could be earned on an investment in the financial markets with similar risk.)
Rt - the net cash flow (the amount of cash, inflow minus outflow) at time t (for educational purposes, R0 is commonly placed to the left of the sum to emphasize its role as (minus) the investment.
The result of this formula if multiplied with the Annual Net cash in-flows and reduced by Initial Cash outlay will be the present value but in case where the cash flows are not equal in amount then the previous formula will be used to determine the present value of each cash flow separately. Any cash flow within 12 months will not be discounted for NPV purpose.
What NPV Means
NPV is an indicator of how much value an investment or project adds to the firm.
With a particular project, if Rt is a positive value, the project is in the status of discounted cash inflow in the time of t. If Rt is a negative value, the project is in the status of discounted cash outflow in the time of t. Appropriately risked projects
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with a positive NPV could be accepted. This does not necessarily mean that they should be undertaken since NPV at the cost of capital may not account for
opportunity cost, i.e. comparison with other available investments. In financial theory, if there is a choice between two mutually exclusive alternatives, the one yielding the higher no-no should be selected.
If... It means... Then...
NPV >
0
the investment would add value
to the firm the project may be accepted
NPV <
0
the investment would subtract
value from the firm the project should be rejected
NPV = 0
the investment would neither gain nor lose value for the firm
We should be indifferent in the decision whether to accept or reject the project.
This project adds no monetary value.
Decision should be based on other criteria, e.g. strategic positioning or other factors not explicitly included in the calculation.
Example
A corporation must decide whether to introduce a new product line. The new product will have startup costs, operational costs, and incoming cash flows over six years. This project will have an immediate (t=0) cash outflow of $100,000 (which might include machinery, and employee training costs). Other cash outflows for years 1-6 are expected to be $5,000 per year. Cash inflows are expected to be
$30,000 each for years 1-6. All cash flows are after-tax, and there are no cash flows expected after year 6. The required rate of return is 10%. The present value (PV) can be calculated for each year:
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Year Cashflow Present Value
T=0 -$100,000
T=1 $22,727
T=2 $20,661
T=3 $18,783
T=4 $17,075
T=5 $15,523
T=6 $14,112
The sum of all these present values is the net present value, which equals
$8,881.52. Since the NPV is greater than zero, it would be better to invest in the project than to do nothing, and the corporation should invest in this project if there is no mutually exclusive alternative with a higher NPV.
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