EN
The commodity market is one of the major players in the financial system as it opens up the trade of metals, energy resources, and agricultural products. It differs from equity markets because it mainly focuses on physical goods that are essential for industrial use and everyday consumption.
In India, commodity trading is done through regulated exchanges, which ensure transparency, structured contracts, and risk management practices for the participants of the market.
Key Takeaways
-
The commodity market is confined to physical goods, which are traded through standardised derivative contracts.
-
Prices are determined by a combination of demand and supply, weather, and other global factors.
-
In India, commodity trading is under the supervision of SEBI and takes place only on designated exchanges.
-
Futures, options, and structured strategies are the tools that help participants in managing price exposure.
Understanding the Commodity Market
The commodity market is a place where the trading of physical goods, i.e., metals, energy, and agricultural products, takes place. This market, in contrast to the stock market that revolves around the ownership of companies, deals in the most basic and semi-processed goods that are necessary for everyday living and industry.
The factors that primarily dictate prices are the demand and supply situation, the climate, politics, and the amount of production. The market facilitates the above-mentioned activities through well-organised exchanges and contracts, which lead to price discovery, risk management, and efficient distribution of goods among different regions.
How to Start Commodity Trading?
Commodity trading involves buying and selling commodities based on price changes. Here is a step-by-step guide to starting to do it.
-
Understanding the market: Before one begins investing, understanding the basics of the commodity trading market is necessary.
-
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 service 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 Trading account gets opened.
-
Making an 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%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.
Overall Methods to Invest in Commodity Markets:
-
Commodities Futures: Buying and selling contracts on exchanges based on the commodity’s future price. A brokerage account is required for this.
-
Physical trading: Some may be physical purchases such as silver and gold in the form of jewellery, coins, bars. This is only a good approach for commodities that are very high in value.
-
Commodity Stocks: You can also invest in stocks offered by companies that operate in commodities; for example, stocks of an oil refinery or agricultural business. This can be less risky than directly betting on commodity prices.
-
Mutual funds, Commodity ETFs and ETNs: Commodity exchange-traded funds (ETFs), exchange-traded notes (ETNs), and commodity-based mutual funds are also commodity sector investment options.
Managed futures, Commodity Pools: These are basically private funds that focus on commodity investment but they are not public and traders have to be approved in order to invest. The potential returns, as well as management costs, may be higher.
It is important to remember that the price and date are not allowed to be altered once the futures contract is in place.
The gains from the contract will be based on the future movement of the price of the commodity.
Let’s look at an example to understand this better.
For instance, consider that gold is priced at Rs 72,000 per 10 grams right now. An investor decides to buy a futures contract for the same, which expires after 30 days, and it is priced at Rs 73,000. Now, the buyer has agreed to buy 10 grams of gold at Rs 73,000 after 30 days from the seller of the futures contract, irrespective of its market price on that day.for the same, which expires after 30 days, and it is priced at Rs 73,000. Now, the buyer has agreed to buy 10 grams of gold at Rs 73,000 after 30 days from the seller of the futures contract, irrespective of its market price on that day.
If the market price of gold on the day of the expiry of the contract is Rs 75,000, the buyer of the contract will gain on his investment as he could now technically buy gold at Rs 73,000 from his futures contract and sell it for Rs 75,000 in the open market. Hence, this is a profit for him, which will be credited to his account.
Commodity Trading in India
The commodity trading in India refers to the process of purchasing and selling derivative contracts that are tied to physical commodities such as gold, crude oil, wheat, and cotton.
In India’s commodity trading markets, participants usually do not claim ownership of a company. They also do not take physical delivery of the commodities. Trades are executed through standardized contracts. In most cases, individual traders settle their positions in cash by closing them before the contract’s expiry date.
India's commodity trading is mainly through futures contracts that are officially traded on recognised exchanges. These futures contracts specify the very things that are to be included and the time limit, and they can only be traded in the lots that have been fixed in advance. Among the leading features that have distinguished India's commodity trading over the years are:
-
Trading with regulated exchanges such as MCX and NCDEX
-
Margin-based participation, where the upfront amount is just a fraction of the contract price
-
Cash settlement for the majority of retail trades, where physical delivery is limited to specific cases only
-
Price movement caused by demand, supply, global trends, and seasonal factors
Market prices keep changing during the trading hours, and the spot price is the current market value of a commodity. Since the year 2015, India's commodity trading market has been regulated by the Securities and Exchange Board of India (SEBI) after the merger with the Forward Markets Commission (FMC).
In order to partake in trading, one needs to have a demat account with NSDL or CDSL along with a trading account. Commodities that can be traded are generally divided into three categories: metals, energy, and agriculture.
Commodity Trading Strategies
Commodity trading strategies outline the structured ways to analyze the price movements and manage the risks in the commodity markets.
Trend Following Strategy
This method tries to catch the price movement, which is supported by the demand or supply. The trend is determined by the use of price charts, moving averages, and momentum indicators such as RSI, which is adjusted to the market direction until a reversal signal is detected.
Range Trading Strategy
This strategy is used when the prices oscillate between the support and resistance levels. The traders keep a watch on the overbought and oversold situations within this range to get a better understanding of price behaviour in the non-trending periods.
Breakout Trading Strategy
Price movement beyond a certain range or chart pattern is followed by the breakout strategies. Such moves are usually accompanied by a rise in trading volume, which indicates stronger market participation and momentum in the new direction.
Hedging Strategy
Hedging is a way of protecting against price risk by taking a contrary position in futures or options. This technique is often employed by producers and companies that are exposed to fluctuations in commodity prices.
Spread Trading Strategy
The strategy of spreads requires the simultaneous purchase and sale of contracts that are connected. Calendar spreads are made up of the same commodity with different months of expiration, whereas inter-commodity spreads include correlated commodities to minimize price risk.
Arbitrage Strategy
In the case of arbitrage, the strategy is to take advantage of the price differences of the same commodity in different markets, contracts, or time periods. Such trading strategies in commodities are based on price inefficiencies rather than directional movement.
Options-Based Strategies
The option strategies employ call and put contracts in accordance with the different market conditions. Methods like covered calls, straddles, and strangles are utilized to control volatility and uncertainty in prices.
Seasonal Strategy
Seasonal strategies draw upon past price trends that are linked to meteorological factors, crop cycles, and seasonal demand patterns for commodities that influence them.
What are Futures in Commodity Trading?
Commodity futures are basically contracts that require the buyer and the seller to execute the exchange of a certain quantity of the commodity at a previously agreed price on a future date. These futures contracts for commodity trading are exchanged through regulated markets, which are responsible for guaranteeing homogeneity, transparency, and price discovery.
In India, futures trading in commodities is a way to control price uncertainty and know market expectations. Producers aiming for price stability and traders who believe in the opposite future price movement are typical participants.
Futures are bought and sold through the margin system, which requires a small amount of money to be put down for the whole value of the contract, thus making the trader vulnerable to both large profits and losses.
Types of Commodities
There are two types of commodities in the market, i.e., hard commodities and soft commodities. Hard commodities are often used as inputs to 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.
Generally, commodities can be classified as:
-
Agriculture: grains, pulses such as corn, rice, wheat, etc
-
Precious metals: gold, palladium, silver, platinum, etc
-
Energy: crude oil, Brent Crude, and renewable energy, etc
-
Metals and minerals: aluminium, iron ore, soda ash, etc
How to Trade Commodities During Inflation?
Investing or trading in a variety of commodities is better than relying on one single asset, as it gives you a better chance of benefiting from inflationary periods. As a trader dealing in futures, it is necessary to identify the type of inflation.
The three main types are:
Cost-push inflation: Production or input costs are carried over to finished consumer goods costs.
Demand-pull inflation: The demand for goods and services is greater than the supply of those goods and services.
Built-in inflation: Wages are increased due to an increase in the cost of living.
Conclusion
Commodities can help with portfolio diversification and provide investors and traders protection against events like inflation. Commodity trading can bring in potentially high rewards, but it also involves high risk. It is crucial to have a solid understanding of how the commodity market dynamics or supply and demand, as well as inflation operate. Research, as always, is an absolute must, along with caution and patience.
Investors can find a broker who guides them through this journey, as a deep understanding of all financial products is necessary to invest their money well. With time and experience, you can build a portfolio with wisely chosen asset classes that can get you the returns you desire.
