Hari Krishnan – Hedging a Commodity Bull Market (S7E4)
Jan 8, 2024
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Hari Krishnan, Head of Volatility Strategies at SCT Capital, explores developing a low carry hedge for a commodity bull market by understanding market positioning, price impacts, perishability, and seasonality. The podcast discusses depressed commodities, producers' incentives, return skewness, fundamental analysis, liquidity constraints, and low-cost, high-convexity strategies in futures and options markets.
Developing a low carry hedge for a commodity bull market by mimicking the business model of grain, metal, and energy companies through financial instruments.
Overcoming challenges of positioning for a commodity bull market by creating engineering solutions with minimal carry costs while capturing potential gains from cheap commodities.
Analyzing market dynamics and understanding the incentives of commodity producers and consumers to identify structural imbalances and biases in futures and options markets for developing options-based strategies.
Deep dives
Developing a Low Carry Hedge for a Commodity Bull Market
Harry Krishnan discusses the genesis of his research, which was prompted by a client's request to develop a low carry hedge for a commodity bull market. By using financial instruments to buy depressed commodities and profit from upside moves, Krishnan aims to mimic the business model of grain, metal, and energy companies. He explores conditional impacts of price on real-world costs, the influence of seasonality, and how understanding the incentives of commodity producers and consumers can provide insights into potential market imbalances. The objective is to develop a strategy that minimizes the impact of market timing while maintaining long-term exposure to a potential commodity super cycle.
Challenges of Positioning for a Commodity Bull Market
Investors face challenges when trying to position themselves for a commodity bull market, particularly when dealing with cheap commodities. The forward curve of cheap commodities is often in contango, leading to high roll costs for futures traders. Traditional approaches, such as owning futures and rolling them, can lead to constant buying high and selling low. Exchange-traded products may suffer from similar issues. To overcome these challenges, Krishnan focuses on creating engineering solutions that provide upside exposure with minimal carry costs, allowing clients to capture potential gains from cheap commodities without being eaten alive by roll costs.
The Importance of Understanding Market Dynamics
Krishnan emphasizes the importance of understanding market dynamics and the incentives of market participants in commodity trading. By analyzing the behavior of commodity producers and consumers, Krishnan identifies structural imbalances that can result in skewed positioning in futures and options markets. He highlights the different risks and hedging needs of farmers, end users, and producers, which can lead to biases in their trading activity. Krishnan also explores how the perishability of certain commodities and the impact of seasonality influence market behavior and pricing.
Applying Options Trading to Commodity Markets
Krishnan discusses his focus on options trading to develop a low carry hedge for commodity markets. He explains that options provide the potential for high convexity and low carry costs when compared to futures trading. By understanding the biases and preferences of market participants, such as the propensity of farmers to sell futures contracts and end users to be net buyers, Krishnan constructs options strategies that take advantage of these behavioral patterns. He also emphasizes the importance of considering liquidity constraints in the options market and the need to work orders patiently in order to achieve desired outcomes.
Factors Affecting Commodity Mispricing and Trade Execution
Krishnan delves into the factors affecting commodity mispricing and trade execution. He highlights the influence of depressed commodity prices, underinvestment in certain markets, and storage costs. Krishnan also considers the impact of seasonality on trading strategies, as well as the differences between old crop and new crop futures contracts. He explains how his research aims to exploit the mispricing in depressed commodities by providing clients with exposure to potential upside moves while minimizing the impact of timing and entry and exit decisions.
In this episode I am joined by Hari Krishnan, Head of Volatility Strategies at SCT Capital and author of the books Second Leg Down and Market Tremors.
This is Hari’s second appearance on the show, but he comes to us with a very different topic: how to develop a low carry hedge for a commodity bull market.
Taking a similar line of thinking to his book Market Tremors, Hari evaluates the market through the perspective of both commodity producers and consumers. By understanding their business incentives, Hari believes he is better able to understand their market positioning and the potential imbalances created in both futures and options markets.
We discuss the conditional impacts of price on real world costs, how perishability impacts derivative markets, and the influence of seasonality.
I hope you enjoy my conversation with Hari Krishnan.
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