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 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:
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:
- Multi Commodity Exchange – MCX
- National Commodity and Derivatives Exchange – NCDEX
- National Multi Commodity Exchange – NMCE
- Indian Commodity Exchange – ICEX
- Ace Derivatives Exchange – ACE
- 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.
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.
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.
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.
Aron, Bachelors in Commerce from Mangalore University, entered the world of Equity research to explore his interests in financial markets. Outside of work, you can catch him binging on a show, supporting RCB, and dreaming of visiting Kasol soon. He also believes that eating kid’s ice-cream is the best way to teach them taxes.