New entrants into the financial markets often wonder about the difference between trading in equities and trading in commodities. As an asset class, equity may be slightly different, but if you were to compare commodity derivatives with equity derivatives, they are broadly the same.
Of course, there are two basic differences at a very technical level. In the case of stock options, the underlying entity is the stock itself, whereas, in the case of commodity options, the underlying entity is the commodity future and not the commodity itself.
The second difference is that when trading in commodities, the trader has the choice of opting for delivery or for square-up. In the case of equity F&O, all transactions are cash-settled only.
The main exception to this is a list of 46 stocks where F&O settlement has to be done compulsorily through delivery only.
Let us look at seven ideas and tips to trade through the commodity exchanges.
1. Since you get higher leverage, you must use it judiciously
All futures are about leverage, and with commodity futures, the margins are lower than equity as the volatility in price is relatively lower. However, it also means that your leverage levels are higher, and hence, must be used judiciously. If you take a long or short position in index futures, you have to pay around 10% margin (that means a 10x leverage), and you have to pay around 15% margin for stock futures (that means a 6.66x leverage). In the case of commodities, the leverage offered is much higher, i.e., about 14-16x. Similar to how profits get inflated, losses also multiply.
2. Make the best of cover orders and bracket orders while trading
You can further enhance your leverage if you put cover orders with inbuilt stop loss. Cover orders define the contours of a trade at the time of initiation itself, while bracket orders focus on a stop loss and profit target at the time of initiation. The best way to use your leverage in commodities judiciously is to draw boundaries for your orders. This reduces your risk and also enhances leverage.
3. You can never get the better of the market trend, so stick to it
When you are trading in commodities, you are trading with the trend. Commodities tend to follow larger cycles and sub-cycles. There would be 10-12 years of up-cycle followed by 7-8 years of down-cycle. This is the long-term trend. Then there are short-term trends such as reactions to news and other announcements/events. A contrarian approach may work well in case of equities, but it may not really help you in commodity trading. Demand and supply trends matter a lot more in commodities.
4. Averaging is never a great idea when trading in commodities
Avoid the temptation of averaging your losses. You may have bought gold or silver at higher prices, and you may be tempted to buy more at lower levels. After all, what can go so wrong with gold? But here, you run two risks. Firstly, you are overexposing yourself to a particular commodity trend. Secondly, you are committing the same mistake twice. You should rather take a fresh view in such cases.
5. Your commodity trading capital is finite, so do not overtrade
You are trading in the commodity markets to make money and not just for the adrenaline rush that it provides. Quite often, aggressive traders have the temptation to over trade, and they try to recover their losses. When you overtrade the commodity market, you only incur more transaction costs and effectively get hit both ways. Stick to your trading plan and focus on the profitability of trades.
6. Margin calls are not done
When you run out of margins and your existing positional risk cannot be supported by the same, your broker will make a margin of call. A margin call is made to ask the trader to infuse more money. Ideally, you should pre-empt that by keeping your trades within limits. A margin call could mean that you need to rush around to arrange funds or risk your positions being squared up forcibly.
7. Focus on risk and the returns will follow
Trading in commodities is all about sticking to a plan, that is, a set of rules that will act as a guide for you. These rules relate to the maximum exposure you will take to a particular commodity position and how much you are willing to lose in a trade in a day and a week. Explicitly, they cover the capacity to conserve your capital and at what point you are willing to shift predominantly onto cash. Discipline is the key.
8. Finally, it is about demand and supply
Commodities are about demand and supply in the long-term and news flows in the short-term. As a commodity trader, this is the basic principle you must focus on.