How do avoid losses during commodity trading?
One of the most important factors that experienced investors swear by is not putting all of your eggs in one basket. Here, the eggs refer to your investments, and the basket is the preferred asset class. The logic behind the idea is that no asset class is without risk and if you put all of your invested amount in one asset class, it can force you to incur huge losses if the asset class enters a bear market, which, in the financial market, is inevitable. If you ask any experienced investor about how you can avoid losses while investing, diversification is the first thing that comes to their mind. However, diversification does not mean that you enter an entirely new asset class just for the sake of diversification.
Rather, it should provide you with added profit potential and a hedge against the crashing of the other asset class. Almost every investor starts with stocks as their first asset class but being restricted to the share market is the biggest mistake they can commit. When the share market enters a bear market, these investors see their investments plunge and are left with no liquidity. At the same time, if you look at the portfolio of experienced investors, almost all of them have investments in commodities and prefer commodity trading.
What are Commodities?
A commodity is an asset class or a group of assets that you use every day, such as oil, metals, spices, pulses, etc. They can be mainly categorized as movable goods that anyone can purchase or sell, except for actionable claims or money.
What is Commodity Trading?
Commodities’ trading involves trading in every kind of movable property other than actionable claims, money, and securities. These include gold, silver, and other metals and select agricultural commodities.
Where to invest in commodities?
India has 22 commodity exchanges that were set up under the Forwards market commission. However, investors mainly prefer the following commodity exchanges for commodity trading:
- National Commodity and Derivatives Exchange – NCDEX
- Multi Commodity Exchange – mcx
- National Multi Commodity Exchange – NMC
- Ace Derivatives Exchange – ACE
- Indian Commodity Exchange – ICEX
- The Universal Commodity Exchange – UCX
Types of commodities
Although there are hundreds of commodities to trade at any of the exchanges; the most common types of commodities are as follows:
Grains: Rice, Basmati rice, wheat, maize, jeera.
Oil and oilseeds: Castor seeds, soy seeds, castor oil, refined soy oil, soy meal, crude palm oil, groundnut oil, mustard seed, cottonseed, etc.
Spices: Pepper, red chili, jeera, turmeric, and cardamom.
Pulses: Chana, urad, yellow peas, tur dal.
|Metals and materials||
Base metals: Aluminum, copper, nickel, zinc, tin.
Bulk commodities: Iron ore, coking coal, bauxite, steel.
Others: Soda ash, chemicals, rare earth metals.
|Precious metals and materials||Gold, silver, platinum, and palladium.|
|Energy||Crude oil, natural gas, Brent crude, thermal coal, alternate energy.|
|Services||Oil services, mining services, and others.|
Different ways of commodity trading
There are two major ways through which commodity traders can trade:
Futures Contract: A commodity futures contract is an agreement between the buyer and the seller of the commodity. The buyers purchase a specific quantity of a commodity at a predetermined price. This contract remains until the price of the bought commodity has risen at the time of the expiry to make a profit.
Options Contract: An options trading contract is generally permitted in top commodities wherein the trader has the right but not a legal obligation to buy/sell the commodity at a fixed price. Such a contract helps investors to make a profit based on price fluctuations without having to buy/sell commodities.
How do avoid losses during commodity trading?
Similar to every other asset class, commodity trading too, comes with its risks. As the prices of the commodities are established by the demand and supply forces, they fluctuate heavily in either direction. Furthermore, as environmental factors like weather and monsoon majorly affect the prices of such commodities, you need to be cautious with commodity trading. Here are some of the best ways you can consider avoiding losses during commodity trading:
Financial Conditions: As commodity trading demands investing money, you must invest an amount after a detailed analysis of your financial situation. It means that you should review your finances and invest an amount that does not create a financial burden on you if you lose your investment entirely. This action is called identifying your risk profile, i.e. how much risk you can afford to take while investing in commodities.
Preferred Commodity Class: You must try the various commodity classes to identify the one most suitable for you. If you want to avoid losses during commodity trading, you must stick to a commodity class you have experience in and allocate your investment amount within the commodities of that class. In this way, the factors that result in losses become lower.
Create a plan: Planning is crucial to avoid losses during commodity trading. Ensure that you create a trading plan backed by a detailed analysis of the sector and the commodity class. Once you have made a trading plan, you should stick to it and not let your emotions get in the way.
Be Disciplined: Discipline is one of the most important factors to avoid losses during commodity trading. You must not get carried away if you are making profits and invest all of your capital without analyzing your risk profile. The same goes when you are in losses; you should wait and not panic and only sell when your investing goals are achieved.
Monitor the market: In commodities, price movements happen in a matter of seconds. If you are not attentive to the market, you can miss your price goals. Furthermore, if it moves downwards, you can lose your profits and even the capital amount. Hence, to avoid losses during commodity trading, you should always constantly monitor the market and your trades.
Take it slow: Traders who are not experienced tend to panic and sell their trades for booking profits as soon as possible. This forces them to miss out on achieving their trading goals and on potential future profits. The same happens with investors when they are making losses; they panic and sell to cut their losses, which makes them realize the losses in reality. Hence, you should take it slow, manage every factor well to avoid losses during commodity trading.
Along with the above ways to avoid losses during commodity trading, there are two other vital ways: Diversification and Stop Loss.
What is ‘diversify your portfolio’ to avoid losses during commodity trading?
Diversification is the holy grail of avoiding losses in the financial market. It means that you do not invest all of your capital in one place. For example, you can diversify your portfolio by investing half of your capital in equities and half in commodities. As commodities have an inverse price relationship with equities, they rise in value if the stock market is falling. This can allow you to hedge against the equity market and ensure that you are liquid and profitable in case one asset class falls. Furthermore, you can diversify within commodities by allocating a percentage of your capital to different commodities.
What does maintaining stop loss mean?
Stop Loss is a financial market feature that allows you to sell your asset automatically if it reaches a specific predetermined price. Stop-loss can be an effective way to avoid losses during commodity trading, as your order will get sold automatically if the prices fall. You can put a stop-loss after determining your risk profile such that you won’t incur losses after a particular price of the commodity. A stop loss is vital to mitigate losses and manage the downside risk of commodity trading.
Commodity prices are relatively less affected by factors influencing the stock markets, and hence, offer an excellent avenue of portfolio diversification for investors. Along with diversification and predictability, an investor can also take advantage of the market’s leverage and liquidity. However, as commodity trading can prove risky, it is always wise to follow the above-mentioned ways to avoid losses during commodity trading. If you have any follow-up questions regarding commodity trading, you can always consult IIFL by visiting the website or downloading the IIFL Markets application.
Frequently Asked Questions Expand All
Commodity trading takes place at the various commodity exchanges where the traders can enter into a futures or an options contract to trade commodities. Just as any other derivative contract, you can buy and sell these contracts and make a profit based on the price movement of the strike prices.
Participants may face the situation of a falling market where the prices of commodities decline by a huge margin. Overall, the risks can be: market risk, liquidity risk, counterparty risk and interconnection risk.