Commodity Derivatives: Meaning, Types and How To Trade

In our previous chapters, we did a deep dive into the concept of commodities, encompassing commodity markets and exchanges and their various participants. If you missed that, here’s a quick recap: Commodities are essential, primary, tangible goods used for typical day-to-day consumption and/or industrial use. They can include agricultural products, metals, energy products, and more. 

Commodity markets, also known as commodity spot markets, are regulated exchanges where buyers and sellers come together to trade commodities. These markets facilitate the immediate buying and selling of commodities at their current spot prices. They provide a platform for market participants to manage their exposure to underlying commodities by trading contracts for future delivery. 

In this chapter, we shall explore another important concept called commodity derivatives, touching upon their types and the regulations that govern them. 

Understanding Derivatives and Commodity Derivatives

A derivative can be defined as a financial contract whose value is derived from an underlying asset or set of assets. It can also be seen as a contract between two or more parties that derive its value based on fluctuations in the underlying asset's price, which could be a stock, currency, or commodity. Derivatives are used for various purposes, including hedging against price risks, speculating on price movements, and managing investment portfolios. 

Now that you know what a derivative is, let’s understand what a commodity derivative is. 

A commodity derivative is a specific type of derivative in which the underlying asset is a commodity. It allows market participants to trade and manage risk associated with commodities without directly owning or physically handling the actual commodities. Commodity derivatives include derivatives based on commodities like agricultural products, energy resources, metals and other goods traded in the commodity markets. 

Currently, per the Securities Contracts (Regulation) Act 1956, there are 91 commodities whose derivatives can be traded, and they are generally demarcated into two types, as mentioned below. 

Agricultural Commodity Derivatives	Non-Agricultural Commodity Derivatives
Cereals (Wheat, rice etc)	Bullions and Gems (Gold, silver, diamonds, etc.)
Pulses (Chana, tur, etc)	Energy commodities (Crude oil, natural gas, etc.)
Spices (pepper, jeera etc)	Metal commodities (Aluminium, copper, iron etc.)
Oilseeds (castor, soybean etc)	Other non-agricultural commodities (Lead, zinc, nickel)

 

Commodity derivatives are crucial in facilitating efficient price discovery, providing liquidity and enabling market participants to manage their exposure to commodity price risk. 

Commodity derivatives are of different types, which we will explore later. But, before that, let’s understand the participants in the derivative markets and their role in the functioning of the commodity markets. 

Who Are the Participants in the Commodity Derivatives Market? 

The commodity derivatives market engages various stakeholders such as farmers, processors, wholesalers, retailers, importers, exporters, traders, arbitrageurs, and government agencies like NAFED (National Agricultural Cooperative Marketing Federation of India Ltd) and FCI (Food Corporation of India) and retail investors. Additionally, financial investors such as Mutual Funds, FPIs, and Category III Alternative Investment Funds (AIFs) play a vital role in the highly interconnected market dynamics.

Another vital participant in the commodity derivative market is the exchanges, which we covered extensively in our last chapter. 

Types of Commodity Derivatives Contracts

Commodity derivatives trading in India encompasses various financial instruments that allow market participants to engage in price speculation or hedging activities related to commodities. These instruments include – Forwards, Futures, Options and Swaps. Each type is explored in detail below – 

• Forwards

Forwards are contracts between two parties to buy or sell a specific quantity of a commodity or an underlying asset at a predetermined price on a future date. Simply think of forwards as a contract between two parties to exchange a certain commodity or asset at a pre-fixed rate and time. 

Now, these contracts are customisable and hence traded over-the-counter (OTC), i.e. exchanges are not involved here. And, because it is customisable, the size depends entirely on the contract’s terms. Note that forward contracts require no collateral, and the settlement is done at the end of the period or on the expiration date. 

Let’s take an example to study forwards better. Imagine a wheat farmer who wants to sell 100 kgs of wheat to a mill owner at ₹30 per kg. The farmer is anticipating or ‘speculating’ a fall in the price of wheat in the future and chooses to enter into a forward contract with the mill to deliver his wheat produce at ₹30 per kg on a fixed date (say three months from the date of the contract). 

Now, three situations can arise here –

• Price rises above ₹30 per kg: If this happens, the farmer will have to sell his produce at ₹30 per kg, even though the rates are higher in the open markets, locking losses. This situation will benefit the buyer, a.k.a the mill in this example, as he gets to procure wheat at ₹30 per kg when the price is actually higher. 
• Price falls below ₹30 per kg: Now, the situation is reversed. The farmer gets to sell his produce at ₹30 even though the market price is below ₹30, thereby locking in profits. The mill here has to buy wheat at ₹30 per kg even when the market price is below ₹30. 

• Price remains at ₹30 per kg: In this case, neither party registers a loss or a profit, and the contract is deemed worthless. 

Now, note a couple of points when concerning forwards–

1. There is no exchange involved here. And that is why forwards have a high counterparty risk (where one party can default). 
2. Forward contracts lack standardisation (due to customisation) and the backing of a clearing house (an intermediary that ensures contract fulfilment and guarantee), increasing risk manifold.
3. Forward contracts do not come under the preview of SEBI and, hence, have no margin requirements.
4. Forward contracts are less liquid. In the above example, it may be a task for a farmer to find a buyer with views opposing his own. The mill agreed to enter the contract because it actually speculated prices would rise. 

• Futures

Future contracts, in contrast to forwards, are standardised agreements traded on organised exchanges. The premise is the same as a forward. The buyer is obligated to purchase, and the seller is obligated to sell a specific quantity of commodity or underlying asset at a predetermined price and future date. 

But here is the difference – the future contracts are fixed through exchanges. Also, these contracts are standardised in terms of quantity, rate, and date as exchanges determine them. And, because an exchange standardises them, the counterparty risk is minimal.

Remember, future contracts are only traded on stock exchanges and cannot be modified. Also, to counter risk, SEBI, which regulates these contracts, requires an individual to deposit a certain initial margin. Furthermore, futures contracts are highly liquid and help in efficient price discovery.

Let’s take an example here – Imagine a trader purchases 20 crude oil barrels at ₹6,000. The contract value is ₹1,20,000. Now, if the price rises to ₹6,700 before the said expiry, the profit that the trader shall make would be ₹14,000. Traders, in general, can settle in cash or ask for physical delivery. However, because it is not physically possible to deliver crude oil, the difference is settled with cash. But, if the price falls on the expiry date, the trader will have to lock in losses. 

• Options

Options are a fascinating aspect of the derivative world and slightly less risky than forwards and futures. Options trading in commodities in India began in 2017 after SEBI’s approval following massive demand. 

An option is a contract that derives value from an underlying asset. Or, options (in context to both equity and commodity markets) are contracts or instruments that provide traders with the right but not the obligation to buy or sell a specified quantity of an underlying asset at a predetermined price and period. 

Options can be American style, wherein traders can exercise their rights to sell or buy before expiry, or European style, wherein traders can buy or sell only on the expiry date. Also, a significant point to note here is that Indian commodity options are options on commodity futures and not the spot market. So, when you look at, say, a commodity crude oil option, the underlying is crude oil futures and not crude oil spot price. 

Let’s now look at two main types of options – The call option and the put option.

• Call option:

A call option gives the buyer the right, but not the obligation, to buy a specified quantity of a commodity at a predetermined price (the strike price) on or before the expiration date. Now, to acquire this right, the buyer pays a premium to the seller or writer of the option. 

Assume a trader anticipates a rise in crude oil prices from ₹6,000 to ₹6,500 in the next three months and enters into an option contract. He will pay a premium for the same. Now, after three months, if the prices rise, the buyer would want to exercise his right to buy crude oil at ₹6000. He locks in profits because the market rate is ₹6,500, but he can purchase the same for ₹6,000. 

Even if the price of crude oil falls, the buyer need not exercise the contract. So, in that sense, the buyer’s loss is limited to just the extent of the premium paid. But profits are unlimited. Think what happens if the price moves to ₹6,700, or ₹7,000 or ₹8000.   

Now, let’s think from the writer or seller’s perspective. The seller will receive the premium as his payment. And he is obligated to sell at the pre-decided price, which in this case is ₹6,000, even though the spot price is ₹6,500. The seller’s maximum profit is his premium, but his losses can be unlimited. 

• Put option:

A put option gives the buyer the right but not the obligation to sell a particular underlying asset (in our case, commodity futures) for a predetermined rate and period. Let’s again understand this with an example. 

Assume a trader expects the price of gold to fall in the next three months. The trader can buy a put option at the current price or the strike price. Let’s say it's ₹50,000. Now, if the price on the expiry date is below ₹40,000, then the buyer can exercise his right and sell the gold at the predetermined price. So, basically, when the strike price is ₹40,000, the trader is able to sell at ₹50,000. 

The traders’ losses here are unlimited because the price can range sharply, too, and to any level. 

• Swaps

Swaps are a complex derivative form. A commodity swap is an agreement between two parties wherein they exchange or swap cash flow based on the cost of the underlying asset and other predetermined conditions. Swaps are mainly used for hedging, wherein one party agrees to swap a commodity against risk based on predetermined factors in the contract. 

Swaps are not traded on exchanges and, hence, are not regulated. And, because of their complexity, they are often handled only by large financial institutions. Oil is the commodity that has the most commodity swaps, but this derivative may be applicable to metals, livestock, etc. 

With swaps, we have covered the different types of derivatives, but here are two important things to remember – 

• Charges: Costs associated with commodity derivative trading may include but are not limited to brokerage fees, commodity transaction tax, stock exchange transaction charges, stamp duty, applicable GST, SEBI turnover fee, and other statutory levies. Additionally, expenses related to commodity storage, handling and delivery may apply.
• Risk: Commodity derivative trading (even equity derivatives, for that matter) is an extremely risky investment. Markets, though dynamic, can sway in any direction at any time and may end up eroding your entire capital. If you are a risk-averse individual or cannot digest losses, this may not be the right asset choice for you.

How Are Commodity Derivatives Traded in India? 

Commodity derivatives trading is the exchange of standardised futures and options contracts (as explained above) for both agricultural and non-agricultural commodities. 

The trading is done on approved electronic platforms hosted by recognised exchanges, which have to adhere to the rules and regulations laid down by SEBI and the government. 

To trade in commodity derivatives in India, you must first open a trading account with a broker registered with the SEBI. After the account setup, traders can access the electronic trading platforms of recognised exchanges like the Multi Commodity Exchange (MCX) and the National Commodity and Derivatives Exchange (NCDEX). 

Before trading, it's important to research and understand the commodities market, including price drivers and trends. You, as a trader, should also be familiar with the specific contract specifications of the commodities you intend to trade, such as lot size and expiry dates, and adhere to risk management practices to mitigate losses. Monitoring market news and reports can provide valuable insights for making informed decisions. Lastly, staying updated with SEBI and exchange guidelines ensures compliance with regulatory requirements.

But what are these rules, and why should you be aware of them? Read below to know more. 

Regulatory Framework Governing the Commodity Derivatives Market

The regulatory structure overseeing the Indian commodity derivatives market operates on a three-tier framework involving the Central Government, the Securities and Exchange Board of India (SEBI), and the commodity exchanges. 

In addition, the Securities Contracts (Regulation) Act of 1956 (SCRA) empowers the government to oversee direct and indirect facets of securities trading and stock exchange operations. The whole legislation is quite comprehensive in its coverage, addressing key issues such as recognition of exchanges, corporations and more. 

We have simplified how this complex web of regulations pans out; read below –

1. Central Agencies and Government: The government is responsible for formulating different policies, determining commodities eligible for trading on exchanges, and more. Under the SCRA, the central government is also authorised to request periodic reports from stock exchanges.  In addition, the central government has the authority to supersede the governing body of a recognised exchange, suspend its business, and prohibit undesirable speculations to help promote a fair and transparent environment. 
2. SEBI: The SEBI acts as the executor of the government's policies, aiming to safeguard investor capital and foster market development. SEBI also regulates market intermediaries such as warehouse services and many others. In addition to that, listed companies are supposed to provide information on commodity risk management policies, exposures, and hedging activities in local and international markets under SEBI's Listing Obligations and Disclosure Regulations.
3. Exchanges: Commodity exchanges are required to follow the rules and regulations set by the securities market and ensure the exchanges adhere to and act in accordance with the law.

How To Trade in Commodity FnO With Angel One?

To trade in Commodity FnO with Angel One, follow these steps:

1. Open a Demat and Trading Account: Register with Angel One to get access to commodities trading on exchanges like MCX.
2. Initial Deposit: To start trading, fund your account with an initial deposit, usually a percentage of the contract value.
3. Margin Requirements: Understand the margin requirements for different commodities to manage your trades effectively.
4. Research and Analysis: Utilise Angel One's research reports and tools for informed trading decisions in the commodity markets.
5. Start Trading: Use the Angel One trading platform to place your trades in the commodity F&O market, keeping track of your positions and market movements.

All these regulations and regulators ensure that markets remain fair and that investor interest is protected.

With this, we draw close to commodities and commodity derivatives. We hope you are clear with all aspects of commodity markets and trading. And, before you trade in them yourself, note that derivatives are an extremely risky asset class. Do your due diligence before entering the complex world of derivatives.