Commodity trading is an age-old financial practice that has been the backbone of global trade for centuries. Unlike stocks or bonds, commodity trading is grounded in tangible assets that range from crude oil to agricultural produce.
In this article, we’ll explore everything about commodity trading—what it is, how it works, and why it’s appealing to investors.
What is Commodity Trading in India?
Commodity trading refers to the buying and selling of commodities in various forms, such as raw materials, agricultural products, energy resources, and precious metals, on dedicated commodity exchanges.
These exchanges provide a platform for participants to trade in standardised contracts for commodities. In India, there are 20+ exchanges that facilitate commodity trading 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 commodities, you need a demat account, a trading account, and a bank account. The Demat account will function as a safe for all your trades and holdings, but you will still need to go through a good broker to place orders on the exchanges.
Commodity Exchanges in India
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)
Types of Commodity Markets
Typically, commodity trading occurs either in derivatives markets or spot markets.
- Spot markets: These markets are also known as “cash markets” or “physical markets,” where traders exchange physical commodities for immediate delivery.
- Derivatives markets: In India, there are two types of commodity derivatives: futures and forwards. Futures contracts are agreements based on the current market value of an asset, giving the owner the right to control it at a later date for a set price. When the contract ends, the actual commodity or asset is physically delivered.
The big contrast between forwards and futures is this: forwards are personalised deals traded directly between parties, while futures are standardised agreements traded on exchanges.
Types of Commodity Investment
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, 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 gases 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 emissions, and white certificates.
Globally, the most-traded commodities include gold, silver, crude oil, Brent oil, natural gas, soybeans, 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, and palmolein
- Energy: Natural gas and crude oil
- Base Metals: Brass, aluminium, lead, copper, zinc, and nickel
- Bullion: Gold and 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, and 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
How Does Commodity Trading Work?
Let’s say you decided to invest in a gold futures contract on a commodity exchange like MCX. You enter into this contract at a price of ₹72,000 per 100 grams of gold. MCX has a margin requirement of 3.5%, meaning you need to pay ₹2,520 upfront to secure this contract.
Now, suppose the price of gold rises to ₹73,000 per 100 grams the next day. In this case, you’ll see a profit of ₹1,000, and this amount will be credited to your linked bank account. On the other hand, if the price drops to ₹72,500 the following day, you’ll experience a loss of ₹500, and this sum will be debited from your bank account.
Commodity trading offers the potential for significant leverage, allowing you to control a larger position with a relatively small initial investment. However, it’s important to note that this also comes with higher risk, as commodity prices can be volatile and subject to frequent fluctuations.
Therefore, investors in commodity markets need to be vigilant and carefully manage their positions to mitigate risk.
Types of Traders in Commodity Investment
- Speculators: Speculators try to predict if the price of commodities like gold will go up or down. If they think it will go up, they buy a contract at a lower price and sell it when the price is higher to make a profit. If they expect prices to go down, they sell the contract at a higher price and buy it back when it’s lower to make a profit either way.
- Hedgers: Hedgers use commodity futures to protect themselves from price changes. For example, a farmer worries about losing money if wheat prices drop during harvest. To avoid this risk, the farmer gets a futures contract. If wheat prices fall in the local market, the futures market profit can make up for the loss. If wheat prices rise during the harvest, the farmer might lose in the futures market but can make more money selling at the higher local market price.
How To Invest in Commodities?
To begin trading in commodities, one must open a trading account with a reputed stock broker. You must follow the steps below.
- Choose a commodity broker: Choose a reputed broker registered with the major commodity exchanges. Conduct market research to find the right broker that suits you.
- Open a trading account: Once you shortlist a stockbroker, you can open a trading account with them. You’ll need to provide personal identification, financial information, and any required documents. Your broker will guide you through the account-opening process.
- Complete KYC: To complete the trading account opening process, you may submit required documents such as identity proof, address proof, and other documents as specified by your broker.
- Fund your trading account: Deposit funds into your trading account. Most brokers offer various payment methods, including bank transfers, online transfers, and checks. Ensure there are enough funds in your account to cover your trading activities.
- Research and analysis: Before trading, conduct thorough research on the commodities that you want to trade. Consider factors like supply and demand, market trends, global events, and weather conditions that can impact commodity prices.
- Taxation and compliance: Be aware of the tax implications of commodity trading in India. Depending on your trading activity, commodities may be subject to capital gains tax or other taxes.
Ways To Invest in Commodity Trading
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 to invest in commodities.
- Direct investment: Investing directly in the commodity
- Derivative contracts: Using commodity derivative contracts to trade 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: 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% 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 for equity investment. There are 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 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 through 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%, then one can buy commodity futures worth ₹1,00,000 by paying only ₹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 are due to the high price volatility of commodities. The price is driven by demand and supply when the demand and supply of goods are inelastic. It means that 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 prices move in the opposite direction with 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, 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 services offered, the proactive customer support team, the soundness of financial advice, margin-processing practises, 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. Start trading in commodities with Angel One today. Open your demat account to start with your financial journey.