what are commodities and What is Commodity Trading?

What is Commodity Trading? Basics of Commodities in India!

Understanding the basics of Commodity Trading in India: Commodity trading had been around in India for hundreds of years. But as history took its course we were victims of invasions, government policies, and their amendments made commodity trading a rarity even though it was flourishing in other countries.

Today with favorable laws being implemented commodity trading is once again being accepted even in rural India. And with the strengthening of our stock markets commodity trading has regained its impotence. Today we try and understand what commodity trading is and the different means through which they can be accessed. 

what is commodity trading

What is a commodity?

Commodities in simple terms are raw materials or agricultural products that can be bought and sold. These are basic goods in commerce used as building blocks of the global economy. One very important characteristic of a commodity is that its quality may differ slightly but is essentially uniform across producers. These commodities are asset classes just like bonds and apart from being exchanged for money in real life they are also traded on dedicated exchanges throughout the world.

Classification of Commodities.

Commodities are classified into 4 broad categories. 

  • Agricultural – Corn, beans, rice, wheat, cotton, etc.
  • Energy – Crude Oil, Coal, and other fossil fuels
  • Metals – Silver, Gold, Platinum, Copper.
  • Livestock and Meat – Eggs, Pork Cattle.

Going through the examples above the characteristics of commodities being uniform becomes clearer. The market treats all goods of the same type as equals regardless of who produced them as long as they meet certain quality requirements. This characteristic is known as fungibility regardless of who mined, farmed or produced. 

Take the example of cold drinks. The demand for a Coke differs from that for Pepsi. This is because the brand too comes into play. Even if one of them loses their quality it still may be favored due to brand loyalty. Let us compare this with a commodity. Never would you have heard that “ the crude oil this year sourced from the US is bad unlike that from Saudi Arabia the previous year”. Despite them having some differentiating properties. Karl Marx describes it best:

commodity quote

What is commodity trading?

Now that we have gone through what commodities are let us have a look at how commodity trading comes into the picture.

1. Commodity trading by buyers and sellers

Commodity trading came into play as a means to protect the buyers and producers from price volatility that takes place. Take a farmer for eg. Inorder to protect himself from future price fluctuations what a farmer can do is enter into a futures contract. A futures contract is a legal agreement to buy or sell a commodity at a predetermined price at a specified time in the future. The buyer of the futures contract has the obligation to buy and receive the underlying commodity when the contract expires. The seller here takes on the obligation to provide and deliver the underlying commodity at the contract expiration date. 

This instrument is useful to farmers as he already knows the production cost of his soft commodity is going to take. Adding the required percentage of profit he can enter into the future contract with the buyer i.e. regardless of what the price in the market 6 months hence he will sell his commodity at Rs.50/kg. The buyer in this contract agrees to buy the commodity at Rs. 50/kg. regardless of the price 6 months hence. The farmer protects himself from losses of price falls but in return also forgoes the additional profit he may make from an increase in price in exchange for guaranteed cash flow.

Such future contracts are available for all categories of commodities. These contracts are also widely used in the airline sector when it comes to fuel. This is done in order to avoid market volatility of crude oil and gasoline.

2. Commodity Speculators

Another type of commodity trader is the speculator. The speculator enters the future contract but never intends to make or take delivery of the actual commodity when the futures contract expires. These investors participate in order to profit from the volatile price movements. Investors here close out their positions before the contract is due in order to avoid making or taking actual delivery of the commodity.

These investors enter into the future contracts generally to diversify their portfolio beyond traditional securities and hedge against inflation. This is because the prices of stocks generally move in the opposite direction o commodities.

In times of inflation the prices of commodities increases. This is because the demand for goods and services increases due to investors flocking to invest in commodities for protection. With the increase in demand, the price of goods and services rises as commodities are what is used to produce these goods and services, their price rises too. This makes commodities a good asset for hedging. Over the years this has also led to various assets traded in the financial markets. These include currencies and stock market indices.

Speculative Trading in Commodities for profit

It goes without saying that commodities are extremely risky because of the uncertainties associated with it. One cannot predict weather patterns, natural calamities disasters, epidemics that may occur. But then why do speculative investors still indulge in commodities if not for hedging and diversification? This is because of the huge potential for profits. Due to the high levels of leverage that exists in a future contract small price movements can result in large returns or losses.

In order to reduce this risk, most futures contracts also provide ‘options’. In the case of options, one has the right to follow through on the transaction when the contract expires. Unlike a future where you are obligated. Hence if the price does not move in the direction that you predicted you would have limited your loss to the cost of the option you have purchased. To understand better we can look at options as placing a deposit on a purchase instead of outrightly purchasing. In case things go sideways the maximum you stand to lose is your deposit.

Commodity trading in India

Commodities just like other asset classes are bought and sold on an exchange. These exchanges are called commodity exchanges and they tend to be specialized for such securities.

The commodity exchanges present in India are:

  1. Multi Commodity Exchange – MCX
  2. National Commodity and Derivatives Exchange – NCDEX
  3. National Multi Commodity Exchange – NMCE
  4. Indian Commodity Exchange – ICEX
  5. Ace Derivatives Exchange – ACE
  6. The Universal Commodity Exchange – UCX

The trading of commodities in the commodity market is regulated by SEBI and facilitated by MCX. The MCX provides a platform for trading in stocks. More than 100 commodities are traded in the Indian Commodity futures markets. Some of the top traded commodities are Gold, Crude oil, Copper cathode, Silver, Zinc, Nickel, Natural Gas, and Farm Commodities.

Also read: How to Trade Commodities in India? Step-by-Step Guide for Beginners!

Other Commodity investment options for individual investors.

Using futures and options to invest in commodities is often challenging for amateur investors. They may prove to be extremely risky for investors who do not have a background or understand how prices or commodities will likely move in the future. Hence investors can also opt for indirect exposure when it comes to commodities in the following ways.

1. Stocks

Investors interested in entering the market for a particular commodity can do so by investing in stocks related to that commodity. For eg. If one is looking to use gold in order to hedge, diversify or make a profit he can go ahead and invest in the stock of a jewelry company, mining company, or any firm that deals in bullion. The advantage that a new investor receives here is that of public information related to the company which will help him make decisions and predictions. The disadvantage that comes along with investing in commodities is that the price of the stock is not purely based on the commodity but is also influences by company-related matters.

2. ETF’s and ETN’s

Investors can make use of ETF’s and ETN’s in order to take advantage of the price fluctuations. Using futures contracts, commodity ETFs track the price of a particular commodity or group of commodities that comprise an index. The price of these indexes is tracked by these ETF’s. In order to simulate the fluctuations in price or commodity index supported by the issuer, ETN’s are dedicated. ETN’s are unsecured debts designed to mimic the price fluctuations of the commodity.

3. Mutual and Index Funds

Mutual funds at times invest directly in commodity-related industries like Energy, Food processing, metals, and mining giving exposure to the portfolio. There also exists a small number of commodity index mutual funds that invest in futures contracts and commodity-linked derivative instruments providing investors with greater exposure to commodity prices.

4. Physical investment in commodities.

Another method through which investors receive exposure to commodities is by investing directly in them i.e. by purchasing physical raw commodities. This is more common with metals as other commodities require a purchase in huge quantities to have any useful impact. We often see people buy gold in times of crisis. This may be done through the purchase of gold biscuits.

Closing Thoughts

Commodity trading provides investors with a vast number of benefits. These benefits range from the increased potential of returns, diversification, and a potential hedge against inflation.

But there also exist a number of disadvantages that mainly revolve around the volatile and speculative nature of the security. The increased opportunities in these markets come with increased risks.  

How to Trade Commodities in India? Step-by-Step Guide for Beginners!

How to Trade Commodities in India? Step-by-Step Guide for Beginners!

A Beginner’s Guide on How to Trade Commodities in India: In olden times, commodities like grains, cotton, oil, cattle, etc were heavily traded among the people and communities to meet their requirements. You might have seen movies of people carrying goods on the top of Camels to trade with others. Not much has still changed even in the 21st century. Even now, people and countries trade these items. And these days, anyone can trade in commodities to make substantial profits, apart from trading in traditional stocks and other derivatives instruments.

In this article, we are going to discuss the step-by-step process of how to trade commodities in India. Here, we’ll first cover the basics like what is a commodity, who are commodity buyers and sellers, the types of commodities traded in India, etc. Later, we’ll get into the technicalities like margin required and how exactly to trade in commodities in India. Let’s get started.

What is a Commodity?

In simplest words, a commodity is any raw material that has a physical form and which can be bought or sold and are interchangeable in nature with another similar commodity.  Some of the traditional examples of commodities include Grains, Wheat, corn, soybeans, or other foodstuffs, Cattle or other stock animals, Cotton, oil, gold, etc.

Investing/trading in commodities is a good way to diversify your portfolio with assets other than stocks, gold, etc. Investors or Traders can buy commodity directly in the spot (cash) market or via derivatives market by trading in Futures and Options.

Types of Commodity traders

There are generally two types of commodity traders – Hedgers and Speculators.

— Hedgers are buyers or producers of commodities that use commodities futures contracts for hedging purposes. These traders take the delivery position of the original commodity when the futures contract expires.

— The second types of trader are the Speculators who enter the market for the sole purpose of profiting from the price movement or volatility of commodity futures contract.

Commodity trading exchanges in India

In India, the commodities are traded via five exchanges. Traders are allowed to trade commodity derivative contracts from any of the following exchanges:

  • National Stock Exchange of India Limited (NSE)
  • Bombay Stock Exchange (BSE)
  • Multi Commodity Exchange of India Limited (MCX)
  • National Commodity and Derivatives Exchange Limited (NCDEX)
  • Indian Commodity Exchange Limited (ICX).

An interesting point to mention here is is that NSE and BSE launched trading in commodities only in 2018. Further, the commodities market is regulated by SEBI. (Earlier it was regulated by Forwards Markets Commission (FMC), which was later merged with the SEBI in 2015). All the commodities in India are traded via the online portals.

Margin required to trade Commodity in India

Commodities are products that require higher-margin, compared to any other product like equity futures or options. Different products under the preview of a commodity require a different amount of margins.

Here is a list of the most actively traded commodity along with the margin required for Normal (or delivery) mode and MIS (Margin Intraday Square off) mode.

Margin required to trade Commodity in India Margin required to trade Commodity in India

Pic: Intraday and Normal margin for various commodities (source: www.zerodha.com)

If we were to carefully look at the picture above, for different commodities the margin varies with the change in the price of the commodity futures contract. The images above clearly give information about the Normal margin, the Intraday margin, and the price levels for which the margins are calculated.

List of commodities traded in India

The commodity sector in India has been divided into five sectors namely – Agriculture, Metals and Materials, Precious metals and materials, Energy and, Services. These sectors are again classified and divided into various constituents.

(Image: List of various commodity sectors and its constituents (source: www.indiainfoline.com))

Tips before Entering the Commodity Trading

Here are a few factors to be kept in mind before deciding to enter the commodity trading:

  • Commodity trading is one the fastest growing product, for trading in India.
  • Although risky by nature, but if done with careful analysis and complete understanding, commodity trading adds the required pinch of diversification to the portfolio.
  • The margin required to trade commodities is slightly on the higher side.
  • The amount of margin required to trade the commodity keeps on changing depending upon changes in the price of futures contact of those commodities.

How to Trade Commodities in India? Step-by-Step Explanation

By now, you would have understood what commodity trading is, its various nuances, the margin requirements, the various players in commodity trading, and the different products. Let us now try and understand as to how does one start commodity trading in India.

For the sake of explanation, we have used Zerodha’s web (as they are the discount brokers with the highest customer base), to explain the steps.

Step 1: You need to have a trading account with one of the brokers that allow commodity trading (for example, Zerodha, Angel broking, 5Paisa, etc.). If you don’t have one, here’s an article on the best discount brokers in India, so that you can pick the one that suits you the best.

After opening the trading account, a separate form has to be filled, which activates the commodity trading along with equity trading in the same account. The margin account for equity trading and Commodity trading is different. The margin of Equity cannot be used for Commodity trading and vice-versa.

Step 2: We need to have a sufficient margin balance in our commodity trading account. Margin is the minimum amount of money required to trade. The amount of margin required varies from a Normal trade to a MIS (Margin Intraday Square off) trade.

The main difference between these two is that in case of Normal trade, the position can be carried over to the next day. However, in case of a MIS trade, the position will automatically get squared off before the end of the day.

The amount of margin required is the least for the Covered order. The covered order is that order for which the stop loss is pre-decided. And, hence the margin is least.

oil trading zerodha futures margin

Now, if we carefully look at all the images above, the first image shows the amount margin required for Crude oil October futures contract in Intraday MIS mode (Margin = Rs. 2,00,410). The second image shows the margin required when we trade NRML (Normal) contract (Margin = Rs. 4,00,882). And the third image shows the amount of margin required for a covered order (Margin = Rs. 88,026).

Step 3: The next important step that we need to consider, is to select the commodities, which we wish to trade. And upon selecting the commodities, it is advised to have all the commodities for various expiries pinned to the watch list.

Watch list of the commodities - How to Trade Commodities in India(Image: Watch list of the commodities (source: www.zerodha.com))

Step 4: After Shortlisting the commodities to be traded, the next step is to place the order. After selecting the contract, we just need to punch in the trade on the ticket.

Now, we have two ways to take the trade – Limit order & Market order. If we place the market then we end up buying or selling at the existing market price. But if we place a limit order then we can choose the price at which we want to place the order.

limit and market order commodity trading

Step 5: The next step while trading options is to check in the order book if the order has been placed.  We can do that by simply clicking on the orders tab, and we can see the list of all the order which have been placed or canceled or executed.

Step 6: The last, but the most important step is the continuous monitoring of the positions. We should always be on the constant lookout for opportunities to trade and always have a stop loss for the existing trade.

Conclusion

In this article, we discussed the step-by-step procedure on how to trade Commodities in India. Here are a few key takeaways from this post:

  • Commodity trading is done by both hedgers and speculators.
  • It is one of the most common form of portfolio diversification method used by investors or traders.
  • The amount of margin required to trade is slightly on the higher side, so the trades must be entered after doing a careful analysis of the technical and fundamental picture.
  • We can do both Intraday (MIS) trading and NRML (delivery based trading) while trading commodities.
  • It is always advised to have proper risk management (stop loss and target) for all the trades

That’s all for this post on how to trade Commodities in India for beginners. I hope it was useful to you. If you still have any queries to related to this topic, feel free to comment below. I’ll be happy to help. Happy Trading and Money Making!!