Modules for Traders
Introduction to Currencies and Commodities
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What is Commodity Market? Meaning, Definition, Basics
Think of your local supermarket. You probably drop by the store on a weekly basis to purchase essentials like rice, wheat, oil, and grains, isn’t it? Now, what are these things that you bought? When you look it up in a dictionary, you’ll find many different words for it.
Ah yes! Commodities. Your local supermarket is also a kind of commodities market, isn’t it? It operates on a small scale, and you get your products from retailers. Now, the commodities markets that we’re going to look at in this chapter are something like that – but they operate on a much larger scale. And there, traders can buy the commodities either directly from the manufacturer or from other traders through an exchange.
To get to know these markets better, let’s begin at the basics.
What is a commodities market?
Objectively, a commodities market is a place where selected commodities are traded between members, based on fixed rules and regulations. In a commodities market, the objectives of trading can be any one of these two:
- To take delivery of the commodities in order to actually use them, or
- To profit from the price movements of the commodities
To regulate the trading of commodities, we have many commodity exchanges operating in the market. Primarily, India has six national commodity exchanges namely,
- Multi Commodity Exchange (MCX)
- National Commodity and Derivatives Exchange (NCDEX)
- Indian Commodity Exchange (ICEX)
- National Multi Commodity Exchange (NMCE)
- ACE Derivatives Exchange (ACE)
- Universal Commodity Exchange(UCX)
In 2018, the National Stock Exchange (NSE) and the Bombay Stock Exchange (BSE) also launched a segment for trading in commodities on their exchanges.
Examples of Commodities Markets
The Indian financial market is completely driven by the economy's demand and supply factors. Price fluctuation for assets is based on these factors since demand and supply are continually changing. Those seeking to earn from the Indian financial industry scour the market for such assets. For some investors, the hunt comes to an end with stocks, while for others, it comes to an end with bonds. Commodities, on the other hand, are where investors with a larger risk appetite wind up. Because the prices of commodities such as pulses, spices, metals, and other items are always shifting, investors prefer to purchase when the prices are low and sell when the prices are higher. Furthermore, producers use commodities trading to protect themselves from price swings and to limit their losses if prices fall unexpectedly. If you're interested in learning more about commodity trading and how it may help you increase your earnings while also diversifying your portfolio, know about commodities trading and its most significant exchange: MCX.
The Multi Commodities Exchange of India Ltd, or MCX, is a commodity exchange founded by the Indian government in 2003. It is India's largest derivatives exchange, including futures and options trading on commodities. The overall volume of commodities futures contracts in 2019-20 increased by 26% over the previous year to Rs 32,424 crores. The Forward Markets Commission controlled the Multi Commodity Exchange of India Ltd till 2015. The FMC was amalgamated with the Securities and Exchange Board of India in 2015, bringing the MCX under SEBI's jurisdiction.
Types of commodities in the market
There are different types of commodities in the Indian financial markets. Here is a preview of some such commodities -
- Base metals like aluminium, zinc, copper, nickel and lead
- Precious metals like gold and silver
- Agricultural products like wheat, sugar, paddy, cardamom and pepper
- Energy sources like crude oil and natural gas
Commodity Market Trading vs. Stock Trading
Access to commodities markets, whether spot or derivatives, is unaffordable for most private investors. Direct access to these markets usually requires the use of a special brokerage account and/or certain authorization. Pooled funds that trade commodities futures, such as CTAs, often only accept accredited investors since commodities are considered an alternative asset class. Ordinary investors may still have indirect access to commodities via the stock market. Stocks in mining and materials industries are often associated with commodity prices, and there are currently a variety of ETFs that follow different commodities or commodities indexes.
These ETFs may help investors diversify their portfolios, but for most long-term investors, equities and bonds will remain the foundation of their holdings. Furthermore, since commodity prices are more volatile than stocks and bonds, commodities trading is often best suited for people with a larger risk tolerance and/or a longer time horizon.
How Commodity Markets Work
Let’s start with an example to properly understand just how commodity markets work. Take a commodity like gold for example. Let’s say that you wish to purchase a gram of gold for investment purposes. And so, with that intention, you go to a commodity exchange, say MCX. Here, you purchase a derivative contract of gold. Now, you can either hold the contract till its expiry or square it off after a few days. If you choose to hold the contract till its expiry, the gram of gold that you purchased will be physically delivered to you. Alternatively, if you choose to square it off after a few days, you will be left with a profit from this transaction.
Just like how the stock market makes it easier to buy and sell the stocks of companies, the commodity markets make it easier for individuals to buy and sell various commodities. Producers and consumers of commodities are not the only players in the commodity market. Speculators, investors, and traders who wish to generate profits by leveraging the price movement of these commodities also take part in the commodity markets.
Types of commodities traded in these markets
Let’s again take a little detour and visit your local supermarket for a bit. You’ll find various kinds of goods put up for sale there, isn’t it? You’ll see manufactured products like stationery items, utensils and clothes. And you’ll also see stuff that’s grown or produced - like fruits and vegetables. Much like this, the goods traded in the commodities market can also clearly be classified into one of types of commodities - hard commodities and soft commodities.
Hard commodities include natural resources like metals and oil reserves that make up the backbone of a country’s economy. Some other examples of hard commodities include gold, silver, iron, steel, aluminium and copper. Metals like these often act as key contributing agents to a country’s export trade. The need and availability of these resources can be monitored on a global scale, mainly because the demand and supply for these hard commodities can be easily gauged or speculated.
Soft commodities are basically goods that are grown and nurtured. Think of agricultural produce, cattle and other livestock and any other agricultural or allied products. Unlike hard commodities, it’s not easy to gauge the price movements of these goods mainly because they are influenced by a number of factors - both local and global. For instance, crops can be impacted either positively or adversely due to seasonal patterns and weather changes. And there’s no way these things can be predicted accurately in advance.
Characteristics of a commodities market
Just like we saw with currency markets, the commodities market is also marked by a number of distinct features. Let’s take a closer look at them to understand the market better.
1. A wide variety of commodities are traded
The commodities market is an interesting space where a wide variety of commodities are traded. You know the basic division now - hard and soft commodities. But when you look closer, you’ll see a huge variety of products. Here’s a preview.
- Crude oil
2. Routinely used for price discovery
Just like how the share market gives you a great deal of insight into the price of stocks and therefore, to a certain extent, the company behind it, the commodities market also offers information about the prevailing prices of commodities consistently. By studying these price movements and speculating upon the potential future trends, it becomes easier to make business decisions, particularly for manufacturing entities who use these commodities as raw material. Wholesale traders can also make use of this information to fix the prices for their retail-facing goods.
3. Used for hedging risk
During times of crisis like wars or recession, traditional financial assets like stocks and bonds often tend to plummet, leading to possible losses for traders. But in times like these, commodities can help hedge against this investment risk. In fact, trading in commodities is also a strategy that’s often used to hedge against the inflation that occurs during crises.
4. A variety of contracts traded
The commodities market includes cash contracts, where you buy and sell commodities for the full price. It also includes futures and options contracts that can be bought and sold for a fraction of the original price, as you’ll recall from our earlier chapters. With such a variety of contracts to choose from, there are many trading strategies that can be employed in the commodities market.
5. A vibrant derivatives segment
The derivatives segment of the commodities market, which consists of futures and options, is particularly vibrant. A huge volume of trades occur on the commodities exchange in this segment each day, meaning that it’s significantly liquid. Traders often seek to take advantage of this factor to make quick gains.
Why to Invest in Commodities: Advantages and Disadvantages
There are many reasons to invest in commodities today. Here are the top advantages of commodity trading.
- Portfolio diversification
- Returns during inflation phases
That said, there are also some downsides you should be aware of. The commodity market carries a high risk, and may offer limited returns.
So, this wraps up our introduction to the commodities market. To truly understand how this space works, we’ll need to look at examples of how trades happen. And that’s just what we’ve explored in our next chapter. Head out there for a beginner’s guide to trading in gold.
A quick recap
- A commodities market is a place where selected commodities are traded between members, based on fixed rules and regulations.
- In a commodities market, the objectives of trading can be to take delivery of the commodities in order to actually use them, or to profit from the price movements of the commodities.
- To regulate the trading of commodities, we have many commodity exchanges operating in the market. Primarily, India has six national commodity exchanges.
- The goods traded in the commodities market can clearly be classified into one of two categories - hard commodities and soft commodities.
- Hard commodities include natural resources like metals and oil reserves that make up the backbone of a country’s economy. Some other examples of hard commodities include gold, silver, iron, steel, aluminium and copper.
- Soft commodities are basically goods that are grown and nurtured. Think of agricultural produce, cattle and other livestock and any other agricultural or allied products.
- The commodities market is widely used for price discovery.
- Commodities can also be used for hedging risks associated with other investments.
- The commodities market also has a vibrant derivative segment.