Commodity trading is one of the foundations for the global trading system that trades various commodities from primary economic sectors acting as building blocks for production. These are raw materials standardized and interchangeable with other goods.
For investors aiming to diversify their portfolios, the commodity derivatives market offers extensive exposure to magnify returns. But before anyone starts trading in the commodity market, it is essential to understand commodity trading basics.
Commodity trading in India occurs in a highly developed and regulated commodity trading market in different exchanges.
What is commodity trading?
The commodity market is vast, with different types of raw materials or primary products being traded. There are about fifty major commodity markets worldwide trading in more than 100 commodities.
Commodity trading offers investors exposure to commodities as investable assets. It happens in a regulated market in different exchanges. For general investors, the commodity derivative market is the best way to invest in the commodity market.
In general, the different types of commodities traded in the market are categorised into three categories.
- Agricultural (chana, soya, beans, jeera, rice, and rubber are few examples)
- Metals (industrial metals like aluminium, copper, and lead, and precious metals like gold and silver )
- Energy (natural gas, crude oil, and coal)
Commodity trading offers portfolio diversification beyond traditional securities. And since commodity price moves in the opposite direction of stocks, investors indulge in commodity trading during the periods of market volatility.
How to start commodity trading?
Commodity trading can be daunting for beginners as well as for seasoned traders. It is because of the unique set of challenges it produces. If done right, commodity trading generates significant returns, which have encouraged many investors to the market. But the risk amount is also similar to trading in stocks. Commodity trading involves buying and selling commodities based on price changes. Here is a step-by-step guide to starting doing it.
Understanding the market:Before one begins investing, understanding the basics of the commodity trading market is necessary. India has six major commodity trading exchanges, namely,
- National Multi Commodity Exchange India (NMCE)
- National Commodity and Derivative Exchange (NCDEX)
- Multi Commodity Exchange of India (MCX)
- Indian Commodity Exchange (ICX)
- National Stock Exchange (NSE)
- Bombay Stock Exchange (BSE)
Selecting an efficient broker:Selecting an efficient and reliable broker is a crucial first step since it will conduct all trading on your behalf. Select a broker based on their experience, rates, trading suite, and services range. If you are a new trader, select a full-service broker who will make trading recommendations to help you make informed decisions.
Opening a trading account:Investors will need to open a separate commodity trading account to trade in the commodity market. Depending on the information provided by the investor, the broker will analyse the risk abilities before accepting or rejecting the account opening request. Once the broker approves, the Demat account gets opened.
Making initial deposit: To start investing, investors will have to make an initial deposit, usually 5 to 10 percent of the contract value. Besides the maintenance margin, traders will need to maintain an initial margin to cover any losses during a trade.
For instance, the initial margin requirement for gold is Rs 3200, which is 10 percent of the trading unit of gold.
Create a trading plan: Once all the procedures are done, the final step requires setting up a trading plan. Without a trading plan, it isn’t easy to sustain in the long run. Besides, the strategy of one trader might not work for another. Hence, you will need a plan that works for you.
Types of commodities
Traders can trade in four major categories of commodities.
Metal: A wide variety of metals like iron, copper, aluminium, and nickel, which are used in construction and manufacturing, are available for trading in the market, along with precious metals like gold, silver, and platinum.
Energy goods: Energy goods used in households and industries are traded in bulk. These are natural gas and crude oil. Other energy commodities that trade are uranium, ethanol, coal, and electricity.
Agricultural goods: A wide variety of agricultural and livestock products trade in the commodity market. For example, sugar, cocoa, soybean, wheat, cotton, and more.
Environmental goods: This group includes renewable energy, carbon emission, and white certificates.
There is another categorisation that classifies goods as hard and soft commodities. Hard commodities include natural resources and mined products, like metals, whereas agricultural and livestock products fall into the soft commodity category.
Commodity trading strategies
Before you invest in the commodity market, you need a strategy. But keep in mind that a technique that worked for one trader might not work for you. So, you need a plan based on your knowledge, risk appetite, profit target and types of commodity market in India. Here are some preliminary rules that will help you devise a commodity trading strategy.
Willingness to learn: Before you step into any domain, it is vital to have a basic understanding of it. Likewise, for commodity trading, you must understand commodity futures and options and how they trade. One way is to spend a lot of time in the market to understand its movement. Several commodities trade in the primary Indian commodity exchanges. Hence, you will have to educate yourself on the functionalities of the commodity market before you start.
Understanding margin requirement: A margin is a great tool when used judiciously. Since margin allows you to place significant bids, understanding margin requirements are essential. Most brokers will require you to maintain minimum margin limits in your trading account and need you to invest more money when there is a shortfall.
Insight on commodity frequency: Some commodities trade throughout the year. Others trade for specific months or depending on the economic cycles. Each commodity contract has different tick values, referring to the financial results of minimum unit price change.
Additionally, many commodity futures contracts can have different specifications regarding taking physical delivery of the underlying commodity, whereas others only have a financial settlement.
Understanding commodity attributes: Each underlying item has a set of specifications regarding price, volumes, spread, open interest, and more. These are the attributes that tell traders about the demand for particular commodity derivatives. Usually, the exchanges offer extensive information on these aspects to help traders make informed choices.
Using trading platforms: Nowadays, trading software has replaced the traditional open cry system. It helps in price discovery. Traders use various applications to bid and sell, discover profit opportunities, and receive buying and selling recommendations.
Market support and resistance: Like any securities market, it is vital to understand the support and resistance levels in commodity trading for successful trading.
When demand decreases, the price begins to fall until it finds the bottom. It attracts buyers in the market, and the price starts to rise again. Similarly, when demand increases, the price increases until it touches the resistance level and the trend reverses. Any trader to trade successfully in the market should be aware of the support and resistance levels.
The knowledge of finding the support and resistance levels involve both technical and fundamental analysis.
Discipline is critical: Discipline is a prerequisite in becoming a successful trader. It is the ability to establish an investment plan and stick to it amid the waves of the market. It also attributes to the capacity of knowing one’s financial limits. Never compromise your assets and the level to withstand complete loss. Seasoned traders know which trades they can successfully execute.
And lastly, never put all the eggs in a single basket. Diversification is the key to successful investment and creating wealth in the long run.
Advantages of commodity trading
Commodity trading has several advantages.
Protection against inflation: When inflation rises, it makes borrowing expensive for companies and impacts their profit-making abilities. As a result, stock prices fall during a period of high inflation. On the other hand, the cost of goods increases, meaning the price of primary goods and raw materials would rise, causing commodity prices to move higher. Hence, when inflation is rising, commodity trading becomes profitable.
Hedging against political events: Events like riots, war, and conflicts disrupt the supply chain, making primary materials expensive, and amid widespread market pessimism, stock prices crash. In such situations, commodity investment can help stem some losses.
High leverage facility: Traders can accentuate their profit potential by investing in the commodity market. It allows traders to take a significant position in the market by paying a 5 to 10 percent margin. This way, even an insignificant price increase can increase profit potential exponentially. Although the minimum margin requirement varies from one commodity to another, it is still less than the margin required in equity investment.
Diversification: Commodities allow investors to diversify their portfolio as raw materials have a negative to low correlation with the stocks. Rising inflation causes commodity prices to rise, which lowers profit margin leaving very little to share with investors. Due to inflation, the cash flow to the equity market also decreases. But due to the negative correlation between stock price and commodities, the commodity market offers effective hedging against inflation.
Transparency: The commodity market is developing and highly regulated. In contrast to the historical open cry method, the modern electronic trading suite has added to the transparency and efficiency of the market. It enabled fair price discovery by broad-scale participation, driven by supply and demand, eliminating any risk of manipulation.
Disadvantages of commodity trading
Despite several advantages, commodity trading has a few disadvantages, which you should know before investing.
Leverage: It can be a double-sided sword, especially if you are inexperienced in margin trading.
Leverage, as discussed before, allows traders to bid big in the market. If the margin is 5 percent, then one can buy commodity futures worth Rs 100,000 by paying only Rs 5000. It means that with the slightest fall in price, traders can end up losing a significant amount.
High Volatility: Higher returns from commodity trading is due to the high price volatility of commodities. The price is driven by the demand and supply when the demand and supply of goods are inelastic. It means despite changes in price, supply and demand remain unchanged, which can significantly alter the value of commodity futures.
Not ideal for diversification: Despite the negative correlation between securities and commodities, the latter is not suitable for portfolio diversification. The theory that commodity price moves in the opposite direction with the stocks doesn’t hold as experienced during the economic crisis of 2008. Increasing inflation, unemployment, and reduced demand halt companies production and impact demand for raw materials in the commodity market.
Low returns but high volatility: Commodity trading needs bulk investment to generate significant returns. The Bloomberg Commodity Index, which is considered the gold standard, showcased that even the most secured government bonds have historically garnered more returns than commodity trading. It is primarily because of the cyclical nature of the products, which erodes the value of an investment for buy-and-hold investors. Even the secured treasury bills generate higher returns at lower volatility than the commodity market.
Asset concentration: Even when the primary reason to invest in commodities is to diversify the portfolio, commodity investment tools often concentrate on one or two industries, meaning a higher concentration of assets in one segment.
FAQs on Commodity Trading
What is the cash price of a commodity?
The commodity price refers to the actual goods’ price when bought and sold in the real world. It can include other expenses like the cost incurred for transportation and storage of the product.
What does commodity mean?
In the parlance of commodity trading, commodities are primary products or raw materials like metal, agricultural goods, livestock, and energy products that are available for trading in the commodity market.
How is commodity trading regulated?
The Securities And Exchange Board of India regulates the commodity market. There are six commodity exchanges in the country where traders trade in a wide range of products. The commodity market is highly developed and one of the most regulated markets.
What items are considered a commodity?
Commodities in the commodity market are available under three major categories.
- Agricultural commodities
- Metal commodities
- Energy commodities
What is the present system of regulation in commodity forward/futures trading in India?
The Forward Market Commission (FMC) is the regulator of the commodity futures market. The current regulation system follows a three-tier approach comprising the Ministry of Finance, Forward Market Commission (FMC), and the exchange.
The government of India formulates the policies regarding futures trading. The FMC, which came into being in 1953, approves the Rules and Regulations of the exchanges following the government’s policies. And thirdly, the bourses provide the platform and framework for trading. The Forward Market Commission regulates the market using the Forward Contract (Regulation) Act of 1952.