KNOW EXIT OR NO EXIT
Most traders spend the preponderance of their time and mental focus on deciding when & under what conditions to enter a trade. Traders specializing in the physical commodity markets must also consider how they are going to get back out of an exposure.
Markets can become dramatically cheap or expensive, oversupplied or undersupplied, and those conditions can be short-term shocks or long-term changes to the fundamental landscape. The market can offer tremendous opportunities, but a trader must take care to first understand why the market is priced the way it is, then how they intend to monetize their intended position.
Trading is a game of information asymmetry. The physical commodity markets have many risks not present in more traditional financial markets, including (but certainly not limited to) the potential for constraint or disruption in production, transportation, processing, shipping, storage and receipt of material. A trader evaluating a proposed transaction in a new or unfamiliar product must always be aware that, while they may be a more sophisticated market participant in general, they are very likely less informed than the current inhabitants of that specific market. This is called adverse selection, transacting with counterparties who are more informed about the actual risks present in the market. In emerging commodity markets it is almost impossible to avoid completely, but its effects must be understood and, to the maximum extent possible, minimized.
One hopefully obvious exercise is to attempt to determine as part of the pre-trade evaluation process what change(s) in fundamentals could materially impact the supply/demand balance for the product. A second critical step is to identify who, specifically, is going to be motivated by that fundamental shift to need to step into the market and transact, allowing the trader to exit their position. Someone must take you out. If a trader cannot come up with a scenario where another entity needs to transact, then they cannot take a position in that product.
This happened to me early in my career. I correctly identified a market that was going to rally in price and secured a small long position from a natural seller. The market instantly rallied, and I excitedly called the trader at the company back to sell them back the material I had purchased and book my profit. Except they didn’t want it. They wanted to sell me more. Which makes sense, as they were naturally long. As they hung up the phone, the company’s trader delivered an expensive lesson in one sentence:
“If I wanted to own it, I wouldn’t have sold it to you in the first place.”
It is also important for the trader to consider who else is present in the market they are considering entering. I know of a very, very large structured physical commodity transaction done by a firm that appeared to have an absolutely epic margin baked into it. It would have made the year for the entire desk. There was just one problem. The deal was priced and delivered at relatively esoteric location, one where the only consistently transacting entity happened to be the strongest, most aggressive player in the market. It took a few days, but they inevitably figured out that a new player had a need to transact in size and had no other available counterparty. It ended up making the year for the desk all right, but not the desk that did the deal.
As the saying goes, if you don’t know the exit there is no exit.