Commodity Trading – A Beginners’ Guide to Trading in Commodities

What is commodity trading?

Commodity trading is merely trading in commodity spots and futures (derivatives). A commodity is a primary raw material in commerce which institutions or individuals buy or sell. They are often the building block for more complex goods and services. Commodities are generally divided into 4 categories:

  1. Agricultural- It includes livestock (e.g., cattle, pork bellies, and hogs), industrial crops (e.g., rubber, lumber, and wool), and food crops (e.g., soybeans, corns, and cotton).
  2. Metals – It includes base metals (e.g., aluminum, iron, etc.) and precious metals (e.g., gold, platinum, etc.)
  3. Energy – It includes petroleum products like gasoline and crude oil, heating oil, natural gas, coal, uranium, ethanol, and electricity.
  4. Environmental – It includes products like renewable energy certificates, carbon emissions, and white certificates.

Why should one trade in commodities?

Investors who want to benefit from the price movements, and wish to diversify their portfolio, invest in commodities. There are several reasons why people opt for commodity trading. Some of them are:

1. Diversification

Commodities help to diversify a portfolio. Commodity returns often have low to no correlations with returns of other significant classes like stocks and bonds. This means that usually, when stocks and bonds fall, commodities rise. (Please note: However, this should not be taken as a general rule.)

2. Protection against inflation

Commodities are affected differently from inflation as compared to bonds or stocks. This is because during inflation, the value of currency starts to depreciate. This leads to a decline in the real value of financial assets like bonds and stocks. However, commodities maintain their price and value, even during high inflation.

3. Liquidity

Investment in commodity futures offers high liquidity, in contrast to other assets like real estate. Hence, an investor can quickly liquidate his position in commodity trading.

4. Higher returns

Commodity markets are very volatile, as they can have huge swings in their prices. Well-planned investments in commodity trading can result in higher returns than other assets.

5. Commodity trading on lower margin

The margin deposited with the broker in commodity trading is just 5-10% of the total value. This is much lower than other asset classes’ margins. This allows an investor to take larger positions with less capital, increasing their potential for higher returns as well.

6. Hedge against event risks

Events like wars, natural disasters, and economic crises can depreciate an investor’s assets. These events are known as event risks. While such events might affect bonds and stocks negatively, it can result in the rise of certain commodities.

Major commodity exchanges in India

Some of the major commodity exchanges in India are:

  1. Multi-commodity Exchange of India Ltd, Mumbai (MCX)
  2. National Commodity and Derivatives Exchange of India, Mumbai (NCDEX)
  3. Indian Commodity Exchange (ICEX)
  4. ACE Derivatives and Commodity Exchange Ltd.
  5. National Multi Commodity Exchange, Ahmedabad (NMCE)

Apart from these, there are regional commodity exchanges for commodity trading in India, functioning all over the country.

Advantages and disadvantages of investing in futures

Like everything has its pros and cons, investing in futures has its advantages and disadvantages as well.

1. Stable Margins

Margin requirements for most of the commodities are stable and low, as compared to other asset classes. Hence, an investor knows how much margin he needs to put in a contract.

2. Hedging against price fluctuations

Forward contracts are usually used as a hedging tool in industries that experience high levels of price fluctuations.

3. High liquidity

Future markets are usually very liquid, especially in the case of indexes, currencies, and other commonly traded commodities. Hence, an investor can enter or exit whenever he/she wants.

4. Simple pricing

Future pricing is quite easy to apprehend by most of the investors. It is usually based on the cost-of-carry model. In this, the price of the future is determined by adding the cost of carrying to the spot price.

5. No time decay

Time decay is a phenomenon wherein the value of the assets declines over time, which is quite common in options. However, futures do not have to struggle with time decay.

6. Protection against future risks

A lot of people enter into forward contracts to protect themselves and manage risks in a better way. They are also used to limit risk against foreign currency exchange.

Disadvantages of investing in futures:

1. No control over future events

One of the significant drawbacks of investing in futures markets is that you don’t have any control over the future events.

2. Expiration dates

Future contracts consist of an expiration date. A future contract might become less attractive as the expiration date nears.

Frequently Asked Questions:

1. What are the trading hours for commodities?

Commodity Exchanges are active from 9 AM to 11.30 PM/ 11:55 PM every day (except Saturdays, Sundays, and holidays) for all the non-agricultural commodities. For agricultural commodities, the trading hours are 9 AM to 9 PM.

2. What is contango?

Contango, also known as forwardation, is a situation in which the spot or cash price is lower than the anticipated future price.

3. Who regulates the commodity markets?

The Forward Markets Commission (FMC) regulates the commodity markets in India. It is headquartered in Mumbai and is overseen by the Ministry of Finance.

4. What is a futures contract?

A futures contract is a legal agreement between parties to buy or sell a particular asset of a specific quantity at a predetermined price and date in the future. The underlying asset could be stocks, commodities, bonds, currencies, or interest rates.

How to choose a broker for trading in commodities

Choosing the right broker is essential for successful commodity trading. These brokers act as an intermediate between you and the exchange. An investor should be cautious while choosing their broker for commodity trading in India. Here are some tips to help you choose the right broker for yourself:

  1. Shortlist a few brokers
  2. Check their experience and credibility
  3. Compare charges like brokerage fees
  4. Inspect the quality of their trading platforms
  5. Ensure your broker has an excellent customer support team

Indiabulls Shubh App has now rolled features of commodity trading in India, providing seamless commodity trading experience to its customers.

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