Commodities Structuring Explained: How It All Works

Commodities trading has maintained its popularity over the years. If you’re a newbie that is interested, this could be a guide for you. Specifically when you want to learn certain terminologies like structuring (which we will be talking about). We will discuss how it all works and why it’s necessary in the commodities market. 

In preparation for your commodity trading journey, it never hurts to learn about a few things about how the market works behind the scenes. Ready to learn more about commodities structuring? Let’s get started with the guide right now.

Why is structuring needed in commodities?

You may be aware of how volatile the commodities market is. The price can change suddenly and the supply chain can experience disruptions. When this happens, the risks will exist for those affected by the market from the producers all the way to the investors themselves. Because of these risks, the need for structuring exists. 

So what is commodities structuring? It is the creation and utilization of financial instruments that are addressed to handle specific needs. This includes being able to hedge against price volatility, optimizing your capital efficiency, and accessing new markets you may have an interest in. 

What are the types of structured products?

Commodities structuring as we’ve mentioned consists of several financial instruments. They are designed to address various risk profiles and objectives. So here’s a look at the most common ones that exist and why they are important:

Futures contracts

A futures contract is an agreement that allows you to buy or sell an asset (in this case a commodity) at a price that is pre-determined on a later date. It is considered one of the most popular risk management tools among producers. They do this to lock in their prices and protect themselves from volatile movements (i.e - hedging). 

At the same time, they offer investors exposure to the price movements without them ever owning the underlying asset itself. This isn’t to be confused with this next structured product we’ll cover.

Options contracts

The object of option contracts is that it will give a holder the right to buy or sell a commodity at a specified price within a predetermined time frame. Granted, you do not have the obligation to purchase the underlying asset yourself. This will be an excellent tool for those who want to hedge or use it for speculation purposes. 

There are two types of options: put and call options. A call option pertains to the buying aspect of the asset while the put option ties into the selling aspect.

Swaps

Commodity swaps will focus on the exchange of cash flow that is based on the price performance or one or even an index of commodities. As such, they can be used for managing risk - especially in situations of price movement. These can be used to address specific financial requirements that may vary from one investor to another.

Structured notes

These consist of a combination of traditional bonds with derivative components - both of which are linked to the price of a commodity. The goal here is providing exposure to the investors of the select commodity. Structured notes will give them returns by way of structured payoffs while protecting them from downside price movement.

Exchange-Traded Funds (ETFs)

ETFs are designed to track the performance of a commodity’s prices. At the same time, they will provide investors with access to diversified commodity exposure. ETFs will be traded like equities on the stock exchange. One of the biggest benefits of this structuring is portfolio diversification - which will ensure that you’ll have a stable amount of money rather than risking it all on one asset.

What are the challenges that arise with commodity structuring?

While commodity structuring offers various benefits, there are challenges that exist. Knowing what they are will help you navigate the market easily. Let’s take a look at those challenges right now:

Price volatility

The most common challenge in the markets are price movements - especially volatile ones. These swings can be due to various factors - many of them out of our own control. They include weather events, geopolitical tensions, and other economic indicators. 

Managing this volatility will be a challenge that will be faced by investors. At the same time, producers and consumers themselves will also deal with the same.

Regulatory compliance

Complying with regulatory requirements can be challenging. It can also add on additional costs regarding structuring activities. With this in mind, it is important for participants of the market to stay in the know about any regulation changes so they are able to adhere to them properly.

Many financial news outlets will have information regarding changes in regulatory policies. So be sure to subscribe to the necessary newsletters that will keep you in the loop.

Counterparty risks

Counterparties are often involved in transactions that are structured. If they fail to fulfill their obligations, financial losses may occur. In order to mitigate this risk, investors must perform their due diligence regularly and maintain risk management practices and strategies. Adjust accordingly if necessary.

Liquidity risks

Liquidity constraints may arise even in periods of market stress. When the market becomes illiquid, it can lead to challenges that pertain to entering and exiting your positions at the prices you want. The biggest issue here is that losses can happen - especially if an investor has intentions to exit their position but has difficulty doing so.

Let PermuTrade handle your commodity trading needs

PermuTrade works with all kinds of traders including those interested in commodities. Are you looking to work with experts that will help guide you on the right path? If so, we’d love to hear from you.

In today’s world, commodities are still popular in regards to trading. While the idea of stocks, mutual funds, or even cryptos seem appealing, commodities seem to be a little more underrated. So why not give your portfolio that variety it needs? Contact PermuTrade today and we’ll be happy to help with your trading questions or concerns.