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The volatile onion market - Outside View by Asad Dossani

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The volatile onion market
Dec 27, 2010

Onion prices have been making headlines, as prices recently have been extremely volatile. On December 20th, prices were up 346% over the course of the month. As onions are so widely used, the price rises have become a political issue. In response to the price rise, the government has banned exports and eliminated import duties on onions. The result has been that prices have come down by 50%. Nonetheless, the volatility is big problem. The price is so volatile that in the time between while Iím writing this to the time this article is published, the price could be dramatically higher or lower.

Most of the reasons cited for the price increase have been the poor crop this year that has led to reduced onion production and reduced supply. This makes perfect sense right? Supply is low so prices have gone up. The fact that the crop has been poor is not something new. This was certainly known a few weeks ago before prices skyrocketed. There seems to be no logical reason why the price should go up only in the last couple of weeks. Why then did prices go up so violently?

The reason for this volatility is that there is no futures market for onions. The purpose of a futures market is to allow producers of the commodity to hedge their risks if they think prices may fall. Similarly, the market allows buyers to hedge their risks if they think prices will rise. Not having this market means that buyers and sellers of onions had no way to hedge their risks.

As a result, because there is only a spot market - the commodity is much riskier for both producers and consumers, as they cannot in advance fix the price at which they wish to buy and sell it. This risk gets reflected in the volatility of the spot price.

A futures market has other benefits too. The trading in the commodity is properly regulated by an exchange. This way, it is easier to detect market manipulation. If prices go up or down extremely quickly - it is easy to look through the buy and sell orders that generated the volatility, and hence detect possible manipulation. It is highly likely that some market manipulation has taken place as onion prices rose 346% in 20 days. That magnitude of price rise in such a short time is quite unheard of. A futures market will also bring increased liquidity, which further reduces volatility and reduces transaction costs.

A futures market is not going to make onions any cheaper - if there is a poor crop then prices inevitably will rise. However, a futures market will dramatically reduce the volatility in the market, and make the market a lot more transparent. It would make it easier to plan for and deal with potential shortages and price rises that can arise from a bad crop.

Disclosure: I do not hold the currency/commodity viewed/opined in this column

Asad is an Economics Graduate from The London School of Economics who has also been a part of the currency derivatives team of Deutsche Bank in London. Currently pursuing his PhD at the University of California San Diego where he's researching on Algorithmic Trading Strategies, Asad will be your direct line for answers to all the questions you might have on short-term investing. A part of the Equitymaster Team since 2010, Asad has been sharing his knowledge on short term trading strategies with our valued readers, like you, through our various services. In fact, at the last count, his weekly newsletter, Profit Hunter, was being delivered to more than 100,000 smart traders across the world!

Disclaimer:

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