Commodity futures trading market is one of the most liquid and fast-paced markets and it offers a lot of benefits to both the buyers and the sellers. However, it also has many risks associated with it.
It is primarily used for the purpose of hedging future risks but it is also used for speculative purposes by the seasoned investors.
But before we get into the technicalities of Commodity futures trading, let’s, leave out the futures trading part and just talk about some basics of Commodity trading first.
Commodity Trading is the mechanism through which the top commodities like metals, oil, agricultural products, livestock etc. are traded on the commodity exchanges. It is a simple yet risky process which involves a lot of risks and requires a lot of expertise. Commodity Futures Trading is one specific way of trading in the market.
Commodity trading can either take place in the spot markets or in the futures market.
In the spot market, the trade of commodities happens immediately and at that very time, for cash or in exchange of other commodities, whereas in the futures market, the commodities are traded based on an agreement between the buyer and seller for a future date with a predetermined price.
Commodity Futures Trading Basics
Primarily, Commodity Futures Trading is the process by which the buyer and the seller enter into an agreement to buy or sell a specific amount of the commodity at a future date at a predetermined price. The agreement also contains other details like the quality of the commodity and the mode of delivery.
The buyers use commodity futures trading to fix the price of a commodity that they will be purchasing the future and the sellers use it to protect themselves from the risks of the prices of the commodities going down in the future.
Commodity futures trading performs two important functions of price risk management through hedging and price discovery through speculation.
Commodity Futures Trading is highly organised as it always occurs on the exchanges and the contracts are highly standardised which makes it safe and secure as the markets are highly regulated to ensure fair practices.
In India, commodity futures trading occurs on the exchanges like National Commodity and Derivatives Exchange (NCDEX) and Multi Commodity Exchange (MCX) and the market is regulated by SEBI.
The prices, quality, quantity and delivery time of the commodities is predetermined and has to be adhered to. Like commodity trading, commodity futures trading is also leveraged and can be done on margin payments which are about 5-10% of the entire contract value. Commodity futures can either be directly traded on the exchanges or through commodity exchange-traded funds or commodity mutual funds.
How Commodity Futures Trading Works
The buyer and the seller enter into an agreement to buy or sell a fixed quantity of the commodity at a predetermined price on a future date. At that future delivery date, the price of the commodity would have either gone up or down.
If the price of the commodity goes up, the buyer of the futures contract makes money because he is able to buy the product at a price which is lower than the current market price and he can then make a profit by selling the commodity at the current higher market price.
Similarly, if the price of the commodity goes down, the seller of the contract makes a profit as he is able to sell the commodity at a price that is higher than the current market price.
This is often used by the manufactures, consumers, importers and exporters to lock-in a future price for the commodity to hedge themselves against the risk of price fluctuations. Sometimes, speculators also pursue commodity futures trading to cash in on the expected price movements.
Commodity Futures Trading Example
The simplest example can be studied from an end-user point of view for agricultural products, for instance, tomatoes. At the present date, tomatoes cost, let’s say, ₹25 per kilogram. The consumer anticipates the price of tomatoes to go up in the future due to the poor crop in the present year. He enters into a commodity futures contract for tomatoes at ₹25 per kg.
Now, if in the future price of tomatoes goes up to ₹50 per kg, the consumer still has the ability to purchase them at ₹25 per kg and make a profit of not buying them at a higher current market price.
He hedged himself against the risk of higher prices. At the same time, if the price of tomatoes goes down to ₹20 per kg, the seller of the futures contract makes a profit by being able to sell them at ₹25 per kg against the current market price of ₹20 per kg.
From a larger perspective, a farmer produces 1,000 kg of tomatoes each year and he has to sell them at a good price. So, he enters into a commodity futures contract to sell them at ₹35 per kg where his break-even cost is ₹25 per kg.
Then, if the price of tomatoes goes down to ₹20 per kg he can still sell them at ₹35 per kg and make definite profits but if the price of tomatoes goes up to ₹50 per kg, he will be missing out on the additional profit of ₹15 per kg.
Commodity Futures Trading Advantages
Commodity Futures Trading is an excellent way for the traders, consumers and manufacturers to protect themselves against the risk of price movements in the commodities. They offer many advantages like:
1. Standardisation and regulation:
Commodity futures trading is standardised and regulated, so it protects the rights of both the parties involved and the quality, quantity and other details cannot be manipulated or modified.
It offers high leverage due to which the investors can buy a futures contract on a commodity by paying only 5-10% of the contract value. The investors are thus able to buy more than they have money for and make higher profits.
The good part is that the margins required in the commodity market are much lesser than equity futures and options trading.
For a consumer or an importer/exporter, commodity futures trading offers a huge advantage of being able to protect themselves from future price fluctuations.
By using futures contracts, the importers, exporters and consumers can buy or sell the commodities at a predetermined price and thus save themselves from the risk of a higher/lower price at the time of actual delivery.
4. Limited Manipulation
Since the commodity futures market is driven and governed by international events and market movements, there is a very little chance of any domestic rigging of the price.
Such manipulations are unfortunately part and parcel of equity trading in general.
At the same time, from a producer point of view, he can lock-in the price of his produce and not get affected by negative price movements. The producer can be sure of the price at which he will be selling his product even if the prices go down at the time of actual harvest and selling.
5. Cost control:
From the industries point of view, the price of the raw materials plays a critical role in the final price of the finished product.
By using futures contracts on the raw materials, the industrialists can make sure that the price of their product remains constant and they do not have to pass on the change in the price of raw materials to their consumers and the demand of their product does not get affected due to the price hike.
Commodity Futures Trading Risks
Along with being highly rewarding, commodity futures trading is also quite risky as it involves the volatile commodity markets. The major risks associated with futures trading in commodities are:
The prices of the commodities may go in either direction, so there is always the risk of uncertainty in price movements which may lead to huge losses.
Due to high leverage, the traders may end up losing more than they can afford to. Thus, it becomes way more important for traders to be extra cautious while staying objective in their trading decisions.
3. The Unpredictability of Supply and Demand:
The biggest risk associated with commodity futures trading is that the supply and demand of a commodity are unpredictable and affected by numerous related and unrelated factors. Even if a trader does a lot of research, there may still be factors that he missed on taking into account and they cause unexpected price movements.
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