In the economic market, commodities are essentially the raw materials that are used to make refined goods and thus have their own intrinsic value. Traders come together to buy and sell commodities such as metals, agricultural goods, petroleum on the commodity exchanges
The investors looking to start commodity trading must remember that unlike trading in stocks or bonds of companies, the choice here is to buy and sell actual commodities such as pulses or gold and make gains on that.
Types of commodities
There are two types of commodities in the market, i.e. hard commodities and soft commodities. Hard commodities are often used as inputs make other goods and provide services while soft commodities are mainly used for initial consumption. Inputs such as metals and minerals are classified as hard commodities, while agricultural products like rice and wheat are softer commodities.
Generally, commodities can be classified as:
- Agriculture: grains, pulses such as corn, rice, wheat etc
- Precious metals: gold, palladium, silver and platinum etc
- Energy: crude oil, Brent Crude and renewable energy etc
- Metals and minerals: aluminium, iron ore, soda ash etc
- Services: energy services, mining services etc
What are futures?
While commodity trading may entail physical trades too, it generally takes place in the form of futures contracts. Futures contracts are agreements that assure that a certain commodity will be bought or sold for a particular price at a predetermined date. Traders who work with futures contracts then attempt to bet on the commodity’s price movements.
If the price seems to indicate an upward movement, traders purchase futures, and if they seem to indicate downward movement, they sell futures. This is also known as going long or going short, respectively. Futures contracts are often used by major consumers as a tool to hedge against price movements. Such trading takes place on exchanges such as the National Commodity and Derivatives Exchange.
Types of future contracts
Future contracts on the commodity markets are of two kinds. The first kind is the cash-settlement kind where the net gain/loss on your trade is adjusted from your bank account and margin depending on the price movement.
On the other hand, there are also delivery futures which involve the actual physical handing over of the commodities to the buyer of the futures contract. Under this system, one has to produce the required warehouse receipts to prove the ownership of the goods.
Investors must remember to choose the kind of settlement before entering a futures contract as it is difficult to change later and impossible to change post the expiry of the contract.
Advantages of investing in futures:
- Future markets are very liquid
- Futures generate big profits if carefully traded
- Futures can be bought on margin which limits the upfront cash commitment
- Future contracts are available on a variety of price points and expiry dates
- One can trade on both ends of the price movement through futures
Overall methods to invest in commodity markets:
Commodities Futures: Buying and selling contracts on exchanges on the basis of the commodity’s future price. A brokerage account is required for this.
Physical trading: Some may be physical purchases such as silver and gold in the form of jewellery, coins, bars. This is only a good approach for commodities that are very high in value.
Commodity Stocks: You can also invest in stocks offered by companies that operate in commodities; for example, stocks of an oil refinery or agricultural business. This can be less risky than directly betting on commodity prices.
Mutual funds, Commodity ETFs and ETNs: Commodity exchange-traded funds (ETFs), exchange-traded notes (ETNs) and commodity-based mutual funds are also commodity sector investment options.
Managed futures, Commodity Pools: These are basically private funds that focus on commodity investment but they are not public and traders have to be approved in order to invest. The potential returns, as well as management costs, may be higher.
It is important to remember that the price and date are not allowed to be altered once the futures contract is in place.
The gains from the contract will be based on the future movement of the price of the commodity.
Let’s look at an example to understand this better.
For instance, consider that gold is priced at Rs 72,000 per 10 grams right now. And an investor decides to buy a futures contract for the same which expires after 30 days and it is priced at Rs 73,000. Now, the buyer has agreed to buy 10 grams of gold at Rs 73,000 after 30 days from the seller of the futures contract irrespective of its market price on that day.
If the market price of gold on the day of the expiry of the contract is Rs 75,000, the buyer of the contract will gain on his investment as he could now technically buy gold at Rs 73,000 from his futures contract and sell it for Rs 75,000 in the open market. Hence, this is a profit for him which will be credited to his account.
Commodity trading in India
Commodity trading in India has been regulated by the Securities and Exchange Board of India since 2015 when the Forward Markets Commission merged with it. There are more than 20 exchanges under SEBI, which offer investors the opportunity to trade in commodities.
To start commodity trading, one needs to open a Demat account with the National Securities Depository Limited (NSDL) or Central Depository Services (India) Limited (CDSL). The Demat account functions as a holding account for all your investments in a ‘dematerialised’ or electronic state. The Demat account can then be used through a broker to invest in commodities at any commodities exchange. In addition to the Demat account, one also needs a Trading account that is linked to the Demat account in order to trade in the commodities.
The significant exchanges functional in India right now are:
- – National Commodity and Derivatives Exchange – NCDEX
- – Ace Derivatives Exchange – ACE
- – Indian Commodity Exchange – ICEX
- – National Multi Commodity Exchange – NMCE
- – The Universal Commodity Exchange – UCX
- – Multi Commodity Exchange – MCX
Just like shares of firms, these commodities are traded on exchanges with prices going up and down throughout the day based on the demand and supply. The current price of a certain quantity of a commodity is called a spot price. It is important to remember that commodities are often sold in lots which means that one must buy a minimum amount of a commodity and then in multiples thereafter.
How to start commodity trading?
Commodity trading involves buying and selling commodities based on price changes. Here is a step-by-step guide to starting doing it.
Understanding the market:Before one begins investing, understanding the basics of the commodity trading market is necessary.
Selecting an efficient broker:Selecting an efficient and reliable broker is a crucial first step since it will conduct all trading on your behalf. Select a broker based on their experience, rates, trading suite, and services range. If you are a new trader, select a full-service broker who will make trading recommendations to help you make informed decisions.
Opening a trading account: Investors will need to open a separate commodity trading account to trade in the commodity market. Depending on the information provided by the investor, the broker will analyse the risk abilities before accepting or rejecting the account opening request. Once the broker approves, the Trading account gets opened.
Making initial deposit: To start investing, investors will have to make an initial deposit, usually 5 to 10 percent of the contract value. Besides the maintenance margin, traders will need to maintain an initial margin to cover any losses during a trade.
For instance, the initial margin requirement for gold is Rs 3200, which is 10 percent of the trading unit of gold.
Create a trading plan: Once all the procedures are done, the final step requires setting up a trading plan. Without a trading plan, it isn’t easy to sustain in the long run. Besides, the strategy of one trader might not work for another. Hence, you will need a plan that works for you.
Commodity trading strategies
Before you invest in the commodity market, you need a strategy. But keep in mind that a technique that worked for one trader might not work for you. So, you need a plan based on your knowledge, risk appetite, profit target and types of commodity market in India. Here are some preliminary rules that will help you devise a commodity trading strategy.
Willingness to learn: Before you step into any domain, it is vital to have a basic understanding of it. Likewise, for commodity trading, you must understand commodity futures and options and how they trade, including support and resistance levels, margins etc.
Insight on commodity frequency: Some commodities trade throughout the year. Others trade for specific months or depending on the economic cycles. Each commodity contract has different tick values, referring to the financial results of minimum unit price change.
Additionally, many commodity futures contracts can have different specifications regarding taking physical delivery of the underlying commodity, whereas others only have a financial settlement.
Understanding commodity attributes: Each underlying item has a set of specifications regarding seasonality, volumes, spread, open interest, and more which affect their price. Usually, the exchanges offer extensive information on these aspects to help traders make informed choices.
Discipline: Discipline is a prerequisite in becoming a successful trader. It is the ability to establish an investment plan and stick to it amid the waves of the market. It also attributes to the capacity of knowing one’s financial limits.
Diversification: Never put all the eggs in a single basket.
Hedge against inflation?
Inflation can be broken down as a decrease in purchasing power as a result of a rise in the average price of a particular good or set of goods. Commodity prices tend to go up when inflation is on the rise, thereby protecting investors and traders from the direct impact of inflation. Generally, inflation in the market is not considered good news, but commodities tend to benefit from it. With an increase in demand for goods or services, their prices rise, as do the prices of the commodities that are utilised to provide those goods and services.
As long as the supply of a certain commodity that is high in demand remains scarce, its price will stay high or keep increasing as the supply dwindles further.
Monetary inflation that is longer term, can lead to long-lasting crushing effects on the economy. Here is where commodities can protect traders; precious metals like silver or gold are two traditional commodities that are used as hedges against inflation.
How to trade commodities during inflation?
Investing or trading in a variety of commodities is better than relying on one single asset, as it gives you a better chance of benefiting from inflationary periods. As a trader dealing in futures, it is necessary to identify the type of inflation.
The three main types are:
Cost-push inflation:
Production or input costs are carried over to finished consumer goods costs.
Demand-pull inflation:
The demand for goods and services is greater than the supply of those goods and services.
Built-in inflation:
Wages are increased due to an increase in the cost of living.
Conclusion
Commodities can help with portfolio diversification and provide investors and traders protection against events like inflation. Commodity trading can bring in potentially high rewards, but it also involves high risk. It is crucial to have a solid understanding of how the commodity market dynamics or supply and demand, as well as inflation, operate. Research, as always, is an absolute must, along with caution and patience.
Investors can find a broker which guides them through this journey as a deep understanding of all financial products is necessary to invest your money well. With time and experience, you can build a portfolio with wisely chosen asset classes that can get you the returns you desire.
