What is commodity market? How does it work?

Like any other financial instrument, while commodity derivatives hold opportunities, there are also inherent risks involved.

Jul 30, 2019 09:07 IST India Infoline News Service

Raw materials that are natural and used for the  creation of products are called commodities. Commodities are of two kinds, agri commodities and non-agri commodities. Things that are grown are classified as agri commodities. Natural resources that need to be mined and processed such as oil, gold, silver, etc. classify as non-agricultural commodities. Production and consumption of commodities are influenced by various aspects such as season, climate and availability.

Commodities impact the everyday life and livelihoods of people. Hence, demand is influenced as a link between consumer habits and economic factors. Thus, commodity prices are usually subject to a high degree of fluctuation. Trading of these commodities, happen on virtual platforms called commodity markets. Commodities market may be spot or derivative. There are fifty commodity markets in the world. In India, there are three national level and 24 regional exchanges that facilitate trading in close to sixty commodities.

The three national commodity exchanges in India are:
  • The National Commodity and Derivative Exchange (NCDEX)
  • Multi Commodity Exchange (MCX)
  • The National Multi Commodity Exchange of India
Commodity derivatives
Futures: For investors looking to diversify their portfolio beyond stocks and shares, commodities are an ideal option. Thanks to the commodity exchanges, retail investors can participate in the commodity market with commodity derivatives. You can use commodity futures to make directional price bets on various commodities. Commodity futures are standardised with a predetermined quality, quantity and delivery date. To be able to trade in commodity futures you need to post a margin that is roughly 4-8% of the total value of the contract.

Upon the expiry of the contract, you can choose to take physical delivery of the commodity you have chosen. However, you will need to provide the exchange with all the delivery related information as specified by the exchange at the time of the transaction.

Forwards: A forward contract is a personalised agreement between two parties to buy or sell a particular commodity at a pre-specified date and price. It may be on a cash or delivery basis. Forward contracts do not trade on a centralised exchange and are referred to as over the counter instruments. As forward contracts are not tradeable on a centralised exchange, they carry a higher degree of default risk. They are thus used largely as tools of hedging or speculation.

Trading in commodities
The Multi Commodity Exchange (MCX) is the modern electronic exchange. It is the sixth largest commodity trading exchange in the world. To begin trading in commodity futures, you need a bank account and a separate commodity demat account. You can then open a trading account with any MCX registered broker of your choice.

To trade in a commodity, you need to pay a fixed cost as what is known as the initial margin. It varies in the range of 5-10% of the value of the commodity contract. This margin is payable upfront to the exchange through your broker. Once you have paid this margin, you can make a trade or take a position in the commodity futures market.

Let us understand how a trade works out:
  • Suppose you wish to purchase a gold futures contract of 100gms
  • 100gms of gold may be worth Rs280,000
  • 4-5% margin is the limit set on gold futures
  • You therefore make a payment of Rs14,000
  • Hence, you bought futures representing a large amount of gold at a fraction of the price
  • Effectively, you purchased gold futures when the price per 10gms was Rs28,000
  • The next day the price rises to Rs28500. The difference of Rs500 (28,500-28,000) is credited to your account
  • The next day the price dips to Rs27,500 and the price difference of Rs500 is debited to your account.
  • This profit and loss is called mark to market
  • The margin account is adjusted at the end of each trading day to reflect your gain or loss.
While all these transactions can happen through your broker, as a participant is commodity derivative market, you need to be aware of some risks like:
Market risk: Refers to adverse price movement.
Liquidity risk: If markets are illiquid, the risk of unwinding transactions may be difficult.
Credit risk: On the account of default by counter party.
Operational risk: Though such instances are rare, difficulties in operations due to operational issues such as connectivity, etc. cannot be ruled out.

How much is the risk of trading in commodity derivatives?
Now that you are aware of the risks associated with the commodities trading, it may be fair to say that it is safer to trade in commodity derivatives as compared to stock market. It is statistically proven that trading in commodities is less volatile as compared to stocks. Constant vigilance by the Forwards Markets Commission (FMC) ensures that the prices are strictly market driven and there are no manipulations.

However, like any other financial instrument, while commodity derivatives hold opportunities, there are also inherent risks involved. It is prudent to be aware of these risks as well as have a broad understanding of the commodities derivatives market before you begin to trade.

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