Understand How Does Commodity Market Works in India - Meaning, Advantages & Disadvantages

Last Updated: 4 Feb 2025

The last decade has witnessed a boom in commodity trading. The ease of this form of trading has also improved by leaps and bounds. Investors are not only viewing commodities as hedging instruments but also as a tool to assist in diversification. Let’s understand commodities, their trading, and the boons and banes.

Trading in Commodities

The commodity markets in India are structured through a widespread network of regional exchanges across various states, along with national-level exchanges. This setup is crucial to the country’s agricultural sector, as the diverse agro-climatic conditions lead to differences in crop production and, subsequently, commodity prices. Regional exchanges play an important role in reflecting these local variations, influencing the pricing of grains and other commodities in different parts of the country.

For example, Delhi often sees significantly higher prices than other regions due to its role as a major urban centre with a growing population and heightened demand for food. Contributing factors include the presence of numerous business process outsourcing (BPO) companies and the long working hours of their employees, which further drive up food prices.

In essence, India’s commodity market is a large, organised system for the trading and clearing of various commodities. It serves as a marketplace for basic goods, which are interchangeable with other goods of the same type in commerce.

Features of Commodity Trading

The most distinguishing feature of commodities trading is the maintenance of margin and mark-to-market settlement. A trader must maintain an initial margin which is 5-10% of the contract value. Further, the broker may demand a maintenance margin to protect against loss in unexpected, adverse scenarios.

Lastly, trades in the commodity markets are marked to market. At the end of every trading day, the clearinghouse publishes a settlement price for the commodity. The difference between the settlement price and the contracted future’s price is adjusted. At the expiry of the trade, the difference between the expectations of the contracting parties is settled.

Compared to other financial instruments, the lot size for commodities is substantial. The lot size refers to the quantity of the commodity which is traded in a contract. The lot size of a contract is standardized, and it is determined by the exchange.

A commodity contract can be identified by a combination of the name and lot size of the commodity. Lot sizes are further bifurcated into mini, micro, and standard depending on the commodity quantity. For example, the standard lot size of a gold contract on MCX is 1 kg. Hence, the value of a single contract is quite high and requires a substantial investment.

The tenor of a commodity contract is predetermined unlike stocks and other financial instruments where the decisions are made right away. Hence, investment in commodities tends to be short-term in nature. On expiry, the contract is terminated.

Advantages of Commodity Trading

Trading in commodities has multiple benefits which include:

Diversification: This is the most crucial one. The returns in commodity markets are inversely proportional to equity and debt markets as an increase in commodity prices tend to negatively impact the cost of production and the overall business. Hence, investing a certain percentage into the commodity markets may result in mitigating the risks associated with capital markets.

Perfect hedging tool: For example, prices of metals such as bullion tend to increase at a higher rate than inflation. Investors can enjoy a rise in the real value of their invested corpus. Thus, the commodity trade acts as an inflation hedge. Alternatively, enterprises can fix the price of raw materials by transacting in the corresponding commodity contracts. For example, a cloth manufacturer can freeze the price of cotton and eliminate the risk associated with rising cotton prices. As a result, cash flow management and financial planning improve.

Low margin: Commodity trading has a lower margin as compared to stocks and bond markets. Essentially, the trader has access to borrowed capital and can increase his exposure to commodities. In cases of cash settlement, the differential price is settled, and traders earn higher returns.

Commodity markets are subject to higher volatility since any change in the demand, production capacity or social conditions will directly impact the price of a commodity. Owing to the volatility, the risk and reward are relatively higher.

How Commodity Trading Works?

Commodity trading involves several key steps that allow buyers and sellers to exchange raw materials or agricultural products. Here’s how it works:

• Market Research and Analysis: Traders begin by analysing the market, studying factors like supply and demand, geopolitical events, weather patterns, and economic data that affect commodity prices. Understanding these factors helps forecast price movements.
• Choosing Trading Instruments: Traders can choose different instruments, such as futures contracts (agreements to buy/sell at a future date), spot contracts (immediate transactions at current market prices), and options contracts (the right, but not the obligation, to buy/sell at a set price).
• Placing Orders: Once an instrument is chosen, traders place orders to buy or sell on exchanges such as the Multi Commodity Exchange (MCX) in India.
• Execution: Orders are matched on the exchange, and transactions are executed at agreed-upon prices.
• Settlement: The final step is the settlement, where the commodity is delivered or the contract is settled in cash, depending on the type of agreement.

What Are Commodity Market Instruments?

Commodity market instruments are financial tools used for trading commodities. These include:

• Futures Contracts: Agreements to buy or sell a commodity at a predetermined price on a specified future date.
• Options Contracts: Provide the right, but not the obligation, to buy or sell a commodity at a set price before a certain date.
• Spot Contracts: Immediate purchase or sale of a commodity at its current market price, with prompt delivery.
• ETFs (Exchange-Traded Funds): Investment funds that track commodity prices, allowing investors to gain exposure without directly trading commodities.

Commodity Market in Terms of Spot, Forward, and Option Trading

In the commodity market, traders use various financial instruments to buy and sell commodities. These instruments allow participants to manage risk, speculate on price movements, or simply exchange goods. The three primary types of trading instruments in the commodity market are spot trading, forward contracts, and options trading. Each serves a unique purpose and offers different levels of flexibility and risk management.

Spot Trading

Spot trading involves the immediate exchange of commodities at the current market price, with delivery typically occurring immediately or within a short time frame. This type of trading is used for direct transactions where buyers and sellers settle immediately. It is ideal for those looking to purchase or sell commodities on the spot without any future obligations.

Forward Contracts

A forward contract is an agreement between two parties to buy or sell a commodity at a specific price at a future date. Unlike futures contracts, forward contracts are private, customised agreements and are not traded on an exchange. These contracts allow businesses or traders to hedge against price fluctuations but come with counterparty risk, as they are not standardised.

Options Trading

Options trading gives traders the right, but not the obligation, to buy or sell a commodity at a predetermined price before a specific date. There are two types of options: call options (the right to buy) and put options (the right to sell). This flexibility allows traders to manage risks while having the potential to profit from favourable price movements, making it a popular choice for speculative trading.

Disadvantages of Commodity Trading

Commodity trading offers numerous opportunities, but it also comes with its own set of risks and disadvantages. While it can be a profitable venture, traders must be aware of the challenges involved before participating in the market. Here are the key disadvantages of commodity trading:

• Price Volatility: Commodity prices are highly sensitive to external factors like weather, geopolitical events, and economic changes, leading to significant price fluctuations and increased risk.
• High Leverage: Many commodity trading platforms offer high leverage, which can amplify both gains and losses. This increases the potential for financial distress if market conditions move unfavourably.
• Lack of Liquidity: Some commodities, especially niche ones, may face liquidity issues, making it harder for traders to enter or exit positions without causing significant price impact.
• Market Manipulation: Certain commodities can be subject to market manipulation by large players or cartels, distorting prices and making it difficult for smaller traders to predict market trends.
• Complexity: Commodity markets can be complex, requiring significant knowledge and expertise to navigate, especially when using advanced trading instruments like futures and options.

Final word

The bottom line is that trading in commodities has multiple advantages as well as disadvantages. It is pertinent for an investor to determine their investment objectives and risk appetite before investing owing to a high degree of risk. A commodity trader must be aware of the risks involved and thoroughly analyze the trade, technically and fundamentally. For commodity trading carried out with a robust investment strategy, the sky is the limit!

Frequently Asked Questions

What are examples of trade commodities?

Examples of trade commodities include agricultural products like wheat, corn, and coffee, metals like gold, silver, and copper, and energy resources like oil, natural gas, and coal. These are commonly traded globally.

What are the top 3 commodities?

The top 3 commodities typically include crude oil, gold, and natural gas. These commodities are among the most traded worldwide due to their essential role in global economies and industries.

Which commodity is best for trading?

The best commodity for trading depends on market conditions and the trader’s expertise. Commonly traded options include crude oil, gold, and wheat, as they are liquid, widely available, and influenced by clear global trends.

Is commodity trading legal in India?

Yes, commodity trading is legal in India. It is regulated by the Securities and Exchange Board of India (SEBI), and trading occurs on recognised exchanges such as the Multi Commodity Exchange (MCX) and National Commodity & Derivatives Exchange (NCDEX).

Which is better, stock or commodity?

Whether stocks or commodities are better depends on individual risk tolerance and investment goals. Stocks are generally more stable and long-term focused, while commodities offer higher volatility and short-term trading opportunities, making them suitable for different strategies.

Are commodities high-risk?

Yes, commodity trading is considered high-risk due to price volatility, external factors like weather or politics, and market uncertainty. The potential for large gains is matched by the possibility of significant losses, especially when using leveraged positions.