How to Trade in Commodities Market
In India, the Commodities Market is fairly untapped and underdeveloped. Owing to the risk involved and the cyclical nature of commodities, investors refrain from venturing into this segment. However, it’s a lucrative investments avenue that may be used as a diversification and hedging tool.
This article debunks some myths surrounding the commodities markets and their functioning.
The ABC of the Commodities Market
Commodities are goods that are used in everyday life. These can be exchanged for cash or other goods. Commodities include an array of items ranging from grains, oil, natural gas to crude oil, diamonds, etc.
The price of commodities depends on the principles of demand and supply. Greater the demand for a commodity, higher the price. Inversely, the greater the supply of a commodity, the lower is the price. Other factors affecting the price of a commodity are government policies, cost of production, geopolitical situations, etc. As a result, commodities are volatile securities.
Much like equity shares, you can trade a commodity in an Exchange. Commodities trading is facilitated at spot and futures markets. In spot markets, Commodity Trading is instant and so is the settlement. In the futures market, commodities are traded at a standardized future price and settled on expiry of the contract.
The buyer of the futures contracts has the right to buy the underlying commodity on the predetermined expiry date whereas the seller has the obligation to deliver the same. Additionally, Options contracts are also available for commodities trading, giving the trader a right (but not an obligation) to buy or sell a commodity at a predetermined rate on a specified future date.
In India, commodities are traded on various exchanges – primarily MCX (Multi Commodity Exchange) and NCDEX (National Commodity & Derivative Exchange Limited). It is under the ownership of the Ministry of Finance and regulated by SEBI. Various commodities are traded on exchanges, which are broadly divided into –
- Metal – Aluminium, Zinc, Copper, Lead, Brass, Lead, Nickel
- Bullion – Gold, Silver, Platinum
- Agro Commodities – Cotton, Oil, Pepper, Cardamon, Sugar, Turmeric, Rice, Dal, Maize, Wheat, Soya Bean, Channa, etc.
- Energy – Crude, Natural gas
The list is indicative and does not include all the commodities which are traded on MCX.
An MCX broker acts as an intermediary between the exchange and the investor or trader. To commence trading, a commodity trading account is required to be activated with a commodity broker. The account may be opened online or offline.
Basic documentation such as an application form, KYC documents, bank details, and income proof are required. A member-client agreement is to be executed with the broker. Lastly, the commodities trading account needs to be linked with a demat account.
How to Trade in Commodities Market
Trading in commodities is slightly different as compared to trading in equities. The ticket size and the value of trades are comparatively higher in the commodities market. Because of this, such trades involve maintaining margin money, mark-to-market settlements and effective delivery.
Before executing a trade, an investor is required to maintain an initial margin in his or her commodity trading account. The initial margin is between 5-10% of the total contract value. Subsequently, the investor may place an order through his broker by intimating the number of lots and the contract value. The investor may also need to provide a maintenance margin to cover for loss in case of any adverse, unexpected price movements. The broker may make a maintenance margin call if required.
At the end of each trading day, the clearing house publishes the settlement price for each commodity. The difference between the settlement price and the purchase price of the contract is settled at the end of each trading i.e., the difference in prices is debited or credited from the investor’s account. This mechanism of daily settlements is referred to as ‘mark-to-market’.
A commodities contract can be terminated in two ways:
- Delivery of goods OR
- Cash settlements
The actual delivery of goods has significantly reduced in the recent past. Most contracts are terminated by making cash settlements. Cash settlement refers to the difference in the expectation of the buying and the selling parties.
Overall, trading in commodities can be cumbersome for some considering the daily settlements, margin requirements and other technicalities. As an alternative, exchange-traded funds (ETFs) allow investors to venture into the commodities market without having to enter into individual contracts.
Strategies for Commodity Trading
Before diving into commodity trading, it is important to establish the objective for trading – hedging or diversification.
Commodity futures contracts serve as an excellent hedging tool for those traders, manufacturers or service providers with exposure to the underlying commodities. For example, the airline industry is heavily dependent on fuel for operations. Fuel prices tend to fluctuate sharply. With a commodity futures contract, an airline can fix the price at which fuel will be purchased in the future. In this manner, it will eliminate any volatility in future prices. In turn, cash flow and budgeting may be managed much more efficiently.
Alternatively, commodities can also be used as a tool for diversification. Investors employ different strategies to benefit from changes in price of the underlying commodity. Such trades are generally short term and speculative in nature. More often than not, investors tend to square off their position before the expiry of the futures contract. Hence, actual delivery of the commodities is not very common. A combination of fundamental and technical analysis is employed to arrive at design trading strategies. Final word
To summarize, trading in commodities has its pros and cons. While it is fairly unexplored and volatile, there are a host of investment options available which will aid investors to venture into the commodities market and invest on the basis of their risk appetite.