Guide to Commodity Trading in India
Trading in commodities is not for the faint-hearted. It requires a lot of knowledge, understanding, and experience to make it in this business. However, if done right, trading commodities can be highly profitable. This guide will teach you all about commodity trading in India. You will learn about the different types of commodities that are traded, the main exchanges where trading takes place. By the end of this guide, you will have all the information you need to start trading commodities in India.
What is Commodity?
Commodities are standardised resources or raw materials with intrinsic value used in the production of refined goods. Except for actionable claims and money, it is any movable good that can be bought and sold. Commodity quality may vary, but it must be substantially uniform on some criteria across different producers.
Commodities are traded on exchanges or on the spot market. To be able to trade, commodities must meet the minimum standards set by the exchanges. Traders can purchase these commodities either on the spot market or through derivatives such as options or futures contracts. Beyond traditional securities, commodity trading provides portfolio diversification. Furthermore, because commodity prices move in the opposite direction of stock prices, investors engage in commodity trading during periods of market volatility.
What is 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.
A Commodity market is a place for investors to trade in commodities like precious metals, crude oil, natural gas, energy, and spices, among others. Currently, the Forward Markets Commission allows futures trading in India for around 120 commodities. Trading in commodities is great for investors seeking to diversify their portfolio, as these investments often help with inflation.
Types of Commodities in the market
There are approximately fifty major commodity markets around the world that trade in over 100 commodities. Traders can trade in four major commodity categories:
Metal: The market offers a wide range of metals for trading, including iron, copper, aluminium, and nickel, which are used in construction and manufacturing, as well as precious metals such as gold, silver, and platinum.
Energy goods: Bulk energy goods are traded in households and industries. These are natural gas and petroleum. Uranium, ethanol, coal, and electricity are also traded as energy commodities.
Agricultural goods: The commodity market trades a wide range of agricultural and livestock products. Sugar, cocoa, cotton, spices, grains, oilseeds, pulses, eggs, feeder cattle, and other commodities are examples.
Environmental goods: This group includes renewable energy, carbon emissions, and white certificates.
Gold, silver, crude oil, Brent oil, natural gas, soybean, cotton, wheat, corn, and coffee are the most traded commodities worldwide.
Types of Commodity markets
Commodity trading typically takes place in either derivatives or spot markets.
Spot markets, also known as “cash markets” or “physical markets,” are places where traders exchange physical commodities for immediate delivery.
In India, there are 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 it at a point in the future for a price agreed upon now. When the contracts expire, the commodity or asset is physically delivered.
The main distinction between forwards and futures is that forwards can be customized and traded over the counter, whereas futures are standardised and traded on exchanges.
How Does a Commodity Market Work?
Assume you purchased a gold futures contract on the MCX for Rs. 72,000 per 100 gm. On the MCX, gold has a margin of 3.5%. So you’ll have to pay Rs. 2,520 for your gold. Assume that the price of gold rises to Rs. 73,000 per 100 gm the next day. Rs 1,000 will be credited to the commodity market-linked bank account. Assume it falls to Rs. 72,500 the next day. As a result, Rs. 500 will be deducted from your account.
Participants of Commodity market
The commodity market is driven by speculators and hedgers. They can forecast future price movements by constantly analysing commodity prices. For example, if they predict that prices will rise, they will purchase commodity futures contracts, and when prices do rise, they will be able to sell the contracts at a higher price than they paid for them.
Because they are not interested in the actual production of goods or even taking delivery of their trades, they mostly invest in cash-settlement futures, which provide them with substantial gains if markets move in their favour.
Commodity futures markets are commonly used by manufacturers and producers to hedge their risk. Farmers, for example, will suffer a loss if prices fluctuate and fall during harvest. Farmers can hedge their bets by purchasing a futures contract. As a result, when prices fall in the local market, farmers can compensate by profiting in the futures market. In contrast, if there is a loss in the futures market, it can be offset by gains in the local market.
Commodities are also used as an inflation hedge. Because commodity prices frequently mirror inflation trends, investors frequently use them to protect their funds in times of rising inflation, as inflationary losses can be offset by a rise in commodity prices.
How to start trading in Commodity?
Commodities can be traded in India on any of the 20+ exchanges that facilitate this trade, all of which are regulated by the Securities and Exchange Board of India.
You will need a Demat account, a Trading account, and a Bank account to begin trading in commodities. The Demat account will serve as a repository for all of your trades and holdings, but you will still need to place orders on the exchanges through a good broker.
How to choose a commodity broker?
A good broker gives the impression of credibility and experience. Choose a broker wisely based on the variety of services offered, a proactive customer support team, the soundness of financial advice, margin-processing practises, and not just their fees. Before signing up with a broker, the investor should research the platforms where the investments will be made. For inexperienced investors, a demonstration of the application or media is recommended in a single segment
What Commodity Exchanges are available in India?
The Forward Markets Commission in India has established 22 commodity exchanges. The following commodity exchanges are popular trading venues in India:
- 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)
Different ways of Commodity trading
Traders can invest in commodities in a variety of ways, depending on the type of commodity. Given that commodities are physical goods, there are four main ways to invest in commodities.
- Direct Investment: It is the most popular method of investing in commodities. For example, you can buy gold and silver directly in the form of coins and jewellery. Direct investment in these items, on the other hand, has a high transaction cost. There are also concerns about storage and purity.
- Purchase Stocks: This is yet another method of trading commodities. For example, if you want to trade in energy, you can purchase stock in an energy company. The stock price will closely track the energy price. If you invest in commodities through direct stocks, you can profit even if the commodity is not performing well. For example, if you own shares in a well-established energy company, you can still profit even if energy prices fall due to the company’s strong fundamentals.
- Future Contracts: Using commodity futures contracts to invest in the commodity.
- Commodity ETFs and Mutual Funds: There are numerous commodity-based ETFs and mutual funds. For example, if you want to invest in gold or silver, you can do so through gold or silver ETFs. ETFs have no purity or storage issues because the units are held electronically in your demat account.
What is a Commodity Futures Contract?
A ‘commodity futures contract’ is an agreement in which a trader agrees to buy or sell a certain amount of their commodity at a predetermined rate at a predetermined time. A trader is not required to pay the full price of a commodity when purchasing a futures contract. They can instead pay a cost margin, which is a predetermined percentage of the original market price. Lower margins imply that a large amount of a precious metal, such as gold, can be purchased as a futures contract for a fraction of the original cost.
Is investing in Commodities beneficial?
- Protection against inflation, stock market crash and other black swan events:
Inflation raises the cost of borrowing for businesses and reduces their ability to profit. As a result, during a period of high inflation, stock prices fall. On the other hand, as the cost of goods rises, the price of primary goods and raw materials rises, causing commodity prices to rise. As a result, when inflation rises, commodity trading becomes profitable.
- High leverage facility:
Investing in the commodity market can help traders increase their profit potential. It enables traders to take a large position in the market by paying a 5 to 10% margin. In this manner, even a minor price increase can exponentially increase profit potential. Although the minimum margin required varies by commodity, it is always less than the margin required for equity investment. There are low-cost minimum-deposit accounts available, as well as controlled full-size contracts.
Since raw materials have a negative to low correlation with stocks, commodities allow investors to diversify their portfolio.
Commodity markets are evolving and highly regulated. The modern electronic trading suite has increased market transparency and efficiency, eliminating the possibility of market manipulation. It enabled fair price discovery through widespread participation.
Despite its many benefits, commodity trading has a few drawbacks that you should be aware of before investing.
It can be a two-edged sword, especially if you are new to margin trading. As previously discussed, leverage allows traders to bid aggressively in the market. If the margin is 5%, one can purchase commodity futures worth Rs 100,000 for only Rs 5000. This means that even the smallest price drop can result in significant losses for traders.
- High Volatility
The high price volatility of commodities results in higher returns from commodity trading. When the demand and supply of goods are inelastic, the price is determined by demand and supply. It means that, despite price changes, supply and demand remain constant, which can significantly affect the value of commodity futures.
- Not necessarily immune to inflation
Despite the fact that securities and commodities have a negative correlation, the latter is not suitable for portfolio diversification. The theory that commodity prices move in the opposite direction of stock prices does not hold water, as evidenced by the 2008 economic crisis. Increasing inflation, unemployment, and decreased demand halt company production and have an impact on raw material demand in the commodity market.
- Low returns for buy-and-hold investors
Commodity trading requires a large amount of capital to generate significant returns. The Bloomberg Commodity Index, widely regarded as the gold standard, demonstrated that even the most secure government bonds have historically outperformed commodity trading in terms of returns. It is primarily due to the products’ cyclical nature, which erodes the value of an investment for buy-and-hold investors.
- Asset concentration
Even if the primary reason for investing in commodities is to diversify one’s portfolio, commodity investment tools frequently
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