How Commodity Trading Works
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
Commodities refer to movable goods that we use daily, ranging from grains, cotton, fuel, sugar to metal such as gold, copper, zinc, etc. Commodities are raw material inputs that are used to prepare a variety of finished goods. Therefore, commodities are tangible goods, or physical goods, which can be purchased and traded. They can be broadly classified into the following types:
- Agriculture: grains, copper, sugar, palm oil, rubber, etc.
- Metals: copper, zinc, iron, brass, lead, etc.
- Bullion: gold, silver, and platinum.
- Energy: crude oil, natural gas, uranium, etc.
Commodity prices are a function of demand and supply. The demand for a commodity is directly proportional to its price and the supply of a commodity is inversely proportional to its price. The pricing of a commodity is also fluctuates based on government policies, geopolitical tensions, global economy, factors of productions, etc.
For instance, reduced rainfall in the country may affect the supply of cotton and increase the global price of cotton in that year. Similarly, the advent of electrical vehicles may have an impact on the demand for fuel and result in a price reduction.
Commodity trading involves different types of contracts that derive their value from the underlying commodity. In India, commodity contracts include spot, futures, and options contracts.
- In spot contracts, trading and settlement of commodities in instant.
- Commodity futures are traded at a standardized future price. The buyer of a futures contract has the right and the obligation to buy the commodity at a predetermined rate in the future and the seller must sell the commodity at such prices.
- In an options contract, the buyer has the right but not the obligation to buy the commodity at a predetermined future price.
Unlike shares and securities, commodity contracts involve delivery at the end of the contract, which may be a delivery or cash settlement. Delivery refers to the actual transfer of the physical goods on termination of the contract. Cash settlement involves the settlement of the differential price in the expectation of the contracting parties. Cash settlements are more commonly preferred over delivery.
In India, commodity trading takes place on the MCX Exchange. To trade on MCX, a commodity trading account with an MCX broker is required. The broker will assist you in making the right decisions in your trade. Additionally, the commodity trading account must be linked to the Demat account of the trader. Most contracts entered into by commodities traders are commodity futures that are settled in cash.
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.
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!