labels: investment - general
Are commodities riskier than equities?news
The usually less volatil
25 April 2006

In my opinion, the avalanche of volatility descended upon the global markets thanks to silver. The recent months have seen silver gaining from near 11000 levels around Diwali time to the recent 23000+ levels in April. That shows an appreciation of over 100 per cent in seven months. Surely this return is rarely seen even in equity markets.

The main cause was trader perception, based on the news trigger that Barclays was expected to launch a silver-dedicated exchange traded fund (ETF) in July 06, which meant that the funds so garnered had to be parked in physical investments in silver.

Traders worldwide saw a big demand surge due to this ETF, forgetting that the fund was expected to hit the markets months later and investments in silver would be made even later.

The bigger villain of the piece was the expectation of linear extrapolation. Players who were otherwise sanguine were heard advocating this hypothesis with reckless abandon – "If silver has appreciated by an average of Rs2,500 per month since "n" months, it will continue to appreciate at the same clip and hit 26,000 / 28,000 / 30,000 in so many months…."

The figures I heard were indeed dizzying. Equity traders will recollect how Infosys' rate of growth in the top line and bottom line numbers started a guessing game in 1999 / 2000 as to when Infosys would hit Rs50,000 or even when the topline of Infosys would surpass the (then) current GDP numbers!

The expectations were so high, that the possibility of a correction was just not factored into the investment / trading equations at all. Therein lay the root cause of the problem. Traders were making merry, leveraging their ever increasing positions and not worrying about tomorrow. The slightest hint of a reversal started an avalanche of selling from the weakest hands, accelerating in velocity as technical stop losses were hit.

That the exchanges increased the margins was a logical end result of this mindless speculation rather than the cause of the fall. Investors in commodities may recollect that I had advocated that commodity price trends tend to be longer lived as (especially metals) are mined from underground, production is sold in forward contracts ranging from two to eight quarters in advance and end users factor in their demand supply equations way ahead of the traders and speculators.

Therefore, appreciation or depreciation in prices is slower than equities, but is longer lasting. The recent debacle was a direct result of the speculative excess and unbridled greed in the global markets that resulted in such unparalleled price swings. Since commodities are unlike equities on the basis of their slower / longer trend cycles, the worst mistake a trader can make is to trade commodities like equities.

Since this mistake was committed worldwide, price swings of the magnitude seen in equities was also seen in commodities. Some interesting beta (intra-day volatility) numbers to prove my point. Beta measures the volatility in percentage terms in comparison to 1 per cent volatility in the Nifty (in this case).

Silver has a volatility factor of 0.11 per cent, gold 0.57 per cent, copper 0.04 per cent and steel 0.14 per cent. This shows that commodities are any day far less volatile even than the Nifty 50 index. In my opinion, excessive speculation was the sole culprit behind last week's crash. Traders need to play commodities like commodities and learn to keep the devil within under check.

*Mandatory disclosure: The analyst has long positions in the MCX Aluminium and MCX WTI Crude at the time of writing this article.

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Are commodities riskier than equities?