What is proprietary trading?
If trading is the process of buying or selling securities, products, services or goods in search of profit, proprietary trading looks to do this using a firm's own money. This contrasts with customer trading, where traders profit by charging margins, costs or commissions to clients for execution.
What is a forward curve?
The current trading price of a good or asset is referred to as the spot price. Derivative contracts (futures or forwards) can be used to trade the expected future price of an asset. The traded prices of these derivative contracts at different points in the future can be used to define a forward curve. The forward curve will show the expected prices of an asset at different points in the future as defined by the prices traded by market participants.
What are contango and backwardation?
Contango is the state in which the spot price is lower than the future price. Backwardation occurs when the future prices are lower than the spot price.
What is a cash-and-carry trade?
A common trade in contango markets is a cash-and-carry trade. This trade can occur when the contango market is steep enough for there to be an opportunity to derive a profit through the arbitrage of the spot price and the futures price of the asset. For this to be possible, the combined cost of the spot price of the asset plus the costs of carry must be less than the forward price at which the asset can be sold. The costs of carry (or simply carry) describes the costs associated with holding the asset.
Dodd-Frank and its effect on proprietary trading
The Dodd-Frank Wall Street Reform and Consumer Protection Act was enacted after the 2008 financial crash to protect the US economy by improving accountability and transparency in the financial system. Part of the Act, known as the Volcker Rule, sought to end trading by banks that could be defined as risky and of no benefit to their customers. This included proprietary trading, as it unfairly put the deposits of consumers at risk in the search for trading profits. Proprietary trading still occurs in a variety of institutions including hedge funds and prop trading funds, physical trading houses in the commodities world and other privately owned trading companies.
Which parties are involved in commodity trading?
- Producers or suppliers profit from the exploration, sourcing, production and extraction of commodities.
- Consumers profit from the purchase of commodities.
- Physical trading houses are involved in operations spanning the upstream, midstream and downstream of commodities production and consumption.
- Speculators attempt to derive a profit from trading commodity derivatives with no intention of touching the underlying physical commodities by predicting price movements. The range of commodity speculators is as varied as the products: from traders on exchange floors, to algorithmic trading shops using computer systems co-located with exchanges to take advantage of microsecond advantages in the speed of order execution.
Why do parties use commodity derivatives?
Commodities market participants will typically look to hedge out the risk in their physical commodities exposure using derivatives contracts. There are a multitude of derivatives contracts available, including futures, forwards, swaps, options, swaptions (options on swaps); the list goes on. An airline concerned about higher oil prices may wish to enter into a derivative contract to limit its exposure. To achieve this, it would pay an upfront premium priced according to the market view on the risk of this scenario occurring. Speculators use derivatives as they have no intention of touching the underlying physical commodities and look to profit purely by predicting price differentials.