What are commodities?
Commodities are the standardised resources or raw materials with intrinsic value that are used to manufacture refined goods. It can be categorised as every kind of movable good that can be bought and sold, except for actionable claims and money. The quality of commodities may be variable, but they must be substantially uniform on some criteria across different producers.
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.
Commodities are traded on the spot market or exchanges. The commodities must meet minimum standards set by the exchanges to be able to trade. Traders can either buy these commodities on the spot market or through derivatives such as options or futures. 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.
The commodity market
Similar to any other market, the commodities market is either a physical or a virtual space, where interested parties can trade commodities (raw or primary products) at present or future date. The price is dictated by the economic principles of supply and demand.
Types of commodities
There are about fifty major commodity markets worldwide trading in more than 100 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 oils. 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, cotton, spices, grains, oilseeds, pulses, eggs, feeder cattle and more.
Environmental goods: This group includes renewable energy, carbon emission, and white certificates.
Globally, the most-traded commodities include gold, silver, crude oil, Brent oil, natural gas, soybean, cotton, wheat, corn, and coffee.
Types of commodities traded in India (Multi Commodity Exchange of India – MCX)
- Agricultural commodities: Black pepper, castor seed, crude palm oil, cardamom, cotton, mentha oil, rubber, Palmolein
- Energy:Natural gas, Crude oil
- Base Metals: Brass, Aluminium, Lead, Copper, Zinc, Nickel
- Bullion: Gold, Silver
Types of commodities traded in India (National Commodity and Derivatives Exchange – NCDEX):
- Cereals and pulses: Maize Kharif/south, Maize rabi, Barley, Wheat, Chana, Moong, Paddy (basmati)
- Soft: Sugar
- Fibres: Kappa’s, Cotton, Guar seed, Guar gum
- Spices: Pepper, Jeera, Turmeric, Coriander
- Oil and Oil seeds: Castor seed, Soybean, Mustard seed, Cottonseed oil cake, Refined soy oil, Crude palm oil
Commodity Trading in India
The legal entity that decides, regulates and enforces the rules and procedures for trading commodities, such as the standardised commodity contracts, and other related investment products is the commodities exchange. It is an organised market where various commodities and derivatives are traded.
In India, one can trade commodities by going on any of the 20+ exchanges which facilitate this trade under the regulatory eye of the Securities and Exchange Board of India. Till 2015, the market was regulated by the Forward Markets Commission which was finally merged with SEBI to create a unified regulatory environment for commercial investing.
To start trading in commodities, you will need a Demat account, Trading account and a Bank account. The Demat account will function as a keeper of all your trades and holdings but you will still need to go through a good broker to place orders on the exchanges.
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 (ICEX)
- National Stock Exchange (NSE)
- Bombay Stock Exchange (BSE)
How Does a Commodity Market Work?
Suppose you bought a gold futures contract on MCX at Rs. 72,000 for every 100 gm. Gold’s margin is 3.5% on MCX. So you will be paying Rs. 2,520 for your gold. Suppose that the following day, the cost of gold increases to Rs. 73,000 per 100 gm. Rs 1,000 will be credited to the bank account you have linked to the commodity market. Assume that the day-after, it drops to Rs. 72,500. Accordingly, Rs. 500 will be debited from your bank account.
While you get higher leverage with commodity trading, the risk associated with trading in commodities is also higher as market fluctuations are common.
Types of Commodity Market:
Typically, commodity trading occurs either in derivatives markets or spot markets.
- Spot markets are also known as “cash markets” or “physical markets” where traders exchange physical commodities, and that too for immediate delivery.
- Derivatives markets in India involve two types of commodity derivatives: futures and forwards; these derivatives contracts use the spot market as the underlying asset and give the owner control of the same at a point in the future for a price that is agreed upon in the present. When the contracts expire, the commodity or asset is delivered physically.
The main difference between forwards and futures is that forwards can be customised and traded over the counter, whereas futures are traded on exchanges and are standardised.
What is a Commodity Futures Contract?
The ‘commodity futures contract’ is the agreement that a trader will buy or sell a certain amount of their commodity at a pre-decided rate at a certain time. When a trader purchases a futures contract, they are not required to pay the whole price of the commodity. Instead, they can pay a margin of the cost which is a predetermined percentage of the original market price. Lower margins mean one can buy a futures contract for a large amount of a precious metal like gold by spending only a fraction of the original cost.
Participants of commodity market:
Speculators drive the commodity market, along with hedgers. By constantly analysing the prices of commodities they are able to forecast future price movements. For instance, if the prediction is that the prices will move higher, they will buy commodity futures contracts and when the prices do actually seem to move higher, they can sell the aforementioned contracts at a higher price than what they bought it for. Similarly, if the predictions indicate a fall in prices, they sell the contracts and buy them back at an even lower price, thus making profits.
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.
Manufacturers and producers typically hedge their risk with the help of the commodity futures market. For example, if prices fluctuate and fall during harvest, farmers will have to face a loss. To hedge the risk of this happening, farmers can take up a futures contract. So, when the prices fall in the local market, the farmers can compensate for the loss by making profits in the futures market. Inversely, if there is a loss in the futures market, it can be compensated for by making gains in the local market.
Commodities are also used as a hedge against inflation. As the price of commodities often mirrors the inflation trends, investors often use them to protect their funds in times of rising inflation as the losses due to inflation can be offset by the rise in commodity prices.
Investing in commodities
Depending on the type of commodity, traders can find different ways to invest in commodities. Considering the fact that commodities are physical goods, there are four major ways for investing in commodities.
- Direct investment: Investing directly in the commodity
- Futures contracts: Using commodity futures contracts to invest in the commodity
- Commodity ETFs: Buying shares of ETFs (Exchange-Traded Funds)
- Commodity shares: Buying shares of stock in companies or organisations that produce commodities
Advantages of commodity trading:
Protection against inflation, stock market crash and other black swan events: 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.
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. There is affordable minimum-deposit accounts and controlled full-size contracts
Diversification: Commodities allow investors to diversify their portfolio as raw materials have a negative to low correlation with the stocks.
Transparency: The commodity market is developing and highly regulated. The modern electronic trading suite has added to the transparency and efficiency of the market, eliminating any risk of manipulation. It enabled fair price discovery by broad-scale participation.
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 necessarily immune to inflation: 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 for buy-and-hold investors : 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.
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.
How to choose a commodity broker?
Credibility and experience mark the impression of a good broker. Choose a broker wisely depending on the assortment of offered services, proactive customer support team and soundness of financial advice, margin-processing practices and not just their charges. Before signing up with the broker, the investor should check the platforms through which the investments are going live. A demonstration of the application or media is advised for novice investors.
Hope we have answered your questions on ‘what is commodity trading?’. if you are ready to invest, start by opening a commodity trading account with Angel One.