A commodity refers to any material thing which has its own intrinsic value and can be exchanged for money or other goods and services. Commodities in the context of investment and trading include fuels, agricultural products and metals etc. that are traded in bulk either on a spot market or a commodity exchange.
There are two types of commodities in the market, i.e. hard commodities and soft commodities. Hard commodities are often used as inputs make other goods and provide services while soft commodities are mainly used for initial consumption. Inputs such as metals and minerals are classified as hard commodities, while agricultural products like rice and wheat are softer commodities.
What are commodities?
Generally, commodities can be classified as:
- Agriculture: grains, pulses such as corn, rice, wheat etc
- Precious metals: gold, palladium, silver and platinum etc
- Energy: crude oil, Brent Crude and renewable energy etc
- Metals and minerals: aluminium, iron ore, soda ash etc
- Services: energy services, mining services etc
Commodity trading in India
Commodity trading in India has been regulated by the Securities and Exchange Board of India since 2015 when the Forward Markets Commission merged with it. There are more than 20 exchanges under SEBI, which offer investors the opportunity to trade in commodities.
To start commodity trading, one needs to open a Demat account with the National Securities Depository Limited (NSDL). The Demat account functions as a holding account for all your investments in a ‘dematerialised’ or electronic state. The Demat account can then be used through a broker to invest in commodities at any commodities exchange.
The significant exchanges functional in India right now are:
- – National Commodity and Derivatives Exchange – NCDEX
- – Ace Derivatives Exchange – ACE
- – Indian Commodity Exchange – ICEX
- – National Multi Commodity Exchange – NMCE
- – The Universal Commodity Exchange – UCX
- – Multi Commodity Exchange – MCX
Future contracts options are also available in commodity trading. A futures contract is an agreement between the buyer and the seller in which the buyer promises to pay the amount agreed at the time the deal is closed if the seller delivers the goods at a specified time in the future.
There are two types of traders who use commodity futures. The former are buyers and producers of goods who use commodity futures for the purposes of hedging against price volatility in the future. These traders choose to buy futures contracts of commodities that they are interested in to make sure that they can avail a predefined price in the future even if the market is volatile. For example, a farmer can sell corn futures to protect himself against the risk of losing money if the price drops before harvest.
The second type of commodity trader is commodities speculator. These are traders who engage in commodity trade to gain from the price volatility and grow their wealth. Since they are not interested in the actual production of goods or even taking delivery of their trades, they mostly invest through cash-settlement futures which provide them with substantial gains if the markets move according to their expectations.
Types of future contracts
Future contracts on the commodity markets are of two kinds. The first kind is the cash-settlement kind where the net gain/loss on your trade is adjusted from your bank account and margin depending on the price movement. On the other hand, there are also delivery futures which involve the actual physical handing over of the commodities to the buyer of the futures contract. Under this system, one has to produce the required warehouse receipts to prove the ownership of the goods.
Investors must remember to choose the kind of settlement before entering a futures contract as it is difficult to change later and impossible to change post the expiry of the contract.
Some of the advantages of investing in futures include:
- Future markets are very liquid
- Futures generate big profits if carefully traded
- Futures can be bought on margin which limits the upfront cash commitment
- Future contracts are available on a variety of price points and expiry dates
- One can trade on both ends of the price movement through futures