Commodities


Commodities

How can I trade in commodities?

 

Investors can trade in commodities through offline as well as online channels. Read on to learn more about them.

Once you understand what the commodity market is and how it works, the next logical step is to learn

the process of commodity trading. Commodities can be bought and sold through online as well as offline

channels. Let us understand the meaning, advantages and shortcomings of the two channels.

 

Offline channel

One of the most common ways to buy/sell commodities is to hire a broker. Brokerage houses or brokers

are institutions or individuals licensed to buy/sell commodities on behalf of others. Once you have given

the responsibility of trading commodities to your broker, you can easily manage your portfolio without

actually spending time on it. Since these brokers are experts in commodity trading, they offer

professional advice and personal services to clients.

However, brokers usually charge an annual fee and brokerage commission that is much higher than the

fee charged by online accounts. Besides, it usually takes more time to execute an offline transaction,

which at times may result in losses.

 

Online channel

If you have an online commodities trading account, you can carry out all the transactions yourself. Since

this mode of trading requires no professional service and personal time of brokers, it is usually cheaper

than offline channels. Most companies charge a one-time membership fee, after which you are not

required to pay any maintenance charges. The brokerage fee per transaction is quite low too. This mode

is one of the quickest methods of trading, as it allows you to conduct real-time transactions.

 

 

How does a commodities exchange function? Which are the major commodity

exchanges in India?

 

The working of a commodity exchange is very similar to that of a stock market. Read on to know more.

A commodity exchange acts as a portal or a common place where traders can buy and sell commodities.

Such exchanges enable seamless trading, eliminate the need for middlemen and allow the market to fix

a price that is driven purely by demand and supply of the product.

 

How does a commodity exchange work?

 

Just like the stock market, a commodity exchange serves as a marketplace for buyers and sellers to

engage in trading commodities directly. Trading can be done in two ways: cash/spot and futures. In the

former method, the buyer and seller agree upon a common price of the commodity, and actual physical

delivery of that commodity takes place. The latter is different. Futures contract do not involve spot

delivery of commodities; delivery is fixed for a future date at a price agreed by both the parties.

People engage in this kind of trading mainly because each party gets something out of the deal.

Commodity manufacturers/producers want to hedge their produces against fall in price in the future. On

the other hand, commercial consumers want to lock in goods at a favorable price in order to avoid

paying a higher price later. And individual traders wish to benefit from future movements of commodity

prices.

The entire process is done electronically. The producer submits an offer price and the future delivery

date of the commodity on this exchange. The seller, who agrees to pay that price, enters into a contract

with the buyer. Almost all transactions take place in the similar manner, allowing the actual demand and

supply to determine the price.

 

In India, there are three major national commodities exchanges: National Commodity and Derivatives

Exchange Ltd, Multi Commodity Exchange of India Ltd and National Multi Commodity Exchange of India

Ltd. In addition to these, 18 more domestic commodity exchanges in India are known to function.

Any commodity exchange serves three main functions:

 

- Defines rules and regulations of trading to carry out uniform trading practice

- Provides dispute settlement mechanism

- Circulates price movements and market news to the participating members

 

 

What are commodity futures?

 

Commodity futures are buy/sell contracts of commodities at a price fixed today, but realized on a future date. Read on for more information.

Commodity futures are contracts or agreements between two parties, agreeing to buy or sell certain

units of a commodity on a future date at a fixed price. On this future date, the buyer has to pay the price

that was agreed when the contact was made, and the seller has to transfer the ownership of the said

commodities to the buyer.

 

So, if you believe that the price of a certain commodity, say coffee, will rise in the next couple of weeks,

you can buy a futures contract which promises to sell coffee at today’s price. When this commodity is

transferred in your name, you can sell it at a profit. However, if the price falls, you will have to sell your

contract at a loss.

 

 

Where to trade?

 

Commodity transactions take place on a regulated commodity exchange. While any individual or

institution can take part in such trading, it needs to be done through a broker, who is a member of an

exchange and has the authority to carry out transactions on behalf of the traders.

Commodity futures, like currency derivatives, allow you to operate on a margin. This means that you

need to invest only a small percentage of the total transaction value while trading. This allows you to

earn more profit with a lesser amount (while exposing you to a higher risk).

For instance, many brokers might allow you to buy a futures contract of 1,000 barrels of oil worth

$50,000 for with an initial amount of $5,000. With such exposure, even a small rise in the price could

result in huge profits, and vice versa.

 

Things to remember

While entering into a commodity futures contract, it is important to note that the buyer should sell his

holdings before the expiry of the contract. Not closing an existing position might result in possession of a

large quantity of unwanted commodities.

 

 

What are the major factors that impact commodity prices?

 

Since commodities are traded in the world market, many factors are responsible for the price movements of these commodities. Here’s a look at some of them.

On basis of the sheer volumes traded every day, the commodities market is the world’s second largest

market after the currency market. Given the size of the market and the variety it offers, it is difficult to

identify the precise reasons that bring fluctuations in this market. However, there are a few general

factors that affect the movements of commodity prices in the long and short run. Mentioned below are

a few of them.

 

Demand and supply

 

When demand for a commodity is higher than the supply, its price increases, and vice versa. There is

always some imbalance between the two when it comes to commodities, which results in constantly

fluctuating prices.

 

Weather conditions

 

A majority of commodities traded in the world markets are agricultural goods, and the production of

these goods depends on the weather. Sudden changes in climatic conditions like inadequate rainfall or

draughts might affect the availability of agricultural goods in the world market, causing scarcity and

pushing commodity prices northwards.

 

Economic and political conditions

 

The prices of commodities are also impacted by the economic and political conditions of the countries

that are producing and consuming them. For instance, during the Gulf War in Iraq—which was a major

producer of oil—the price of oil fluctuated very frequently. Moreover, weak economic conditions reduce

the spending power of consumers, leading to fall in demand, which results in movement in prices.

 

Government policies

 

Any changes in the government policy, especially the ones impacting import/export cost to the buyer or

seller will have a huge impact on commodity prices. If, for instance, the Indian government increases

import duty on edible oil, its price will show a proportionate increase, and vice versa.

 

These and some other factors like inflation, seasonal variations, currency movements, etc. are majorly

responsible for price fluctuations in the commodity market.

 

 

What is commodity trading?

 

When physical substances like metals, food grains, etc. are traded in the global market to profit from the expected changes in price, it is called commodity trading.

Commodity trading is the act of buying and selling commodities on major exchanges through

standardized contracts. Before we learn about how this market works, it is essential to understand what

commodities are and why people trade them.

Unlike products with brand names, commodities are essentially goods that have a common price per

unit across geographies (for instance, gold). Raw products that are used to produce other goods and

services are considered commodities. Some of the most common commodities traded around the globe

include metals like gold, silver, copper, etc.; energy products like oil, gas, etc.; agricultural outputs like

corn, sugar, coffee, cotton, etc. The prices of these commodities are determined mainly by the supply

and demand of these goods in the global market.

There are three major national commodities exchanges in India. These are National Commodity and

Derivatives Exchange Ltd, Multi Commodity Exchange of India Ltd and National Multi Commodity

Exchange of India Ltd. Apart from these, about 18 other domestic commodity exchanges are also

operating in India.

 

 

Why commodity trading?

 

While earning profit is one of the chief reasons why people trade in commodities, several other

advantages of this investment also propel investors towards it. One such advantage is liquidity. Due to

the participation of several traders and speculators, the commodity market is among the most liquid in

the world.

Apart from liquidity, commodity trading also provides leverage, which allows traders to operate on

margin. This means that people can make large-value transactions by paying a small part of the total

transaction value.

 

Moreover, commodities allow you to profit from the falling market as well. You can put your money on

the upside as well as the downside movement of commodity prices.

Constant fluctuation in this market is certainly a risk, but it also opens up the opportunity to earn higher

profits. Besides, if positions are hedged appropriately, risk is reduced substantially.

 

 

What is hedging? How is it done through commodity markets?

Hedging is the act of reducing your risk of losing money in the future.

 

Simply put, hedging is a kind of insurance for your portfolio. When people hedge, they are, in reality,

insuring their investment against any unpredicted events. Hedging does not prevent such events, but

reduces the impact they might otherwise have on your portfolio.

Portfolio managers, retail investors, corporations as well as governments use hedging to reduce their

risk exposure. However, when it comes to trading in commodities, hedging is not as simple as paying

your insurance premium. To offset the risk arising from one instrument, traders use other instruments.

 

 

How does it work in commodity trading?

 

The prices of commodities fluctuate constantly. If traders want to protect themselves from the risk of

future fluctuations, they buy or sell positions in the futures markets.

Let us understand this with the help of an example. If an individual involved in sugar processing believes

that the price of sugar—which is currently say Rs 20/kg—will increase in the coming months, he will buy

a position in the futures market at today’s price. So, even if the price rises from Rs 20/kg to Rs 23/kg in a

month, he will get a price of Rs 20/kg from the seller at the end of the contract. This act of buying long

positions to avoid upside risk in the futures market is called long hedging.

Similarly, if a farmer anticipates that the price of wheat might fall from Rs 50/kg to Rs 40/kg, he will sell

future contracts at today’s price (i.e. Rs 50/kg). So, even if the price falls to Rs 40/kg, he will still get Rs

50/kg according to the contract. This act of selling positions in the future market in order to protect

one’s investments against downside risk is called short hedging.