Commodity Trading

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Commodity Trading is one of the most upcoming forms of trading in India that has seen a gradual trend. In this detailed review, let’s try to understand the basics of this form of trading, how it works, what are the best ways you can use it for trading before we talk about the pros and cons.

Commodities are an important part of everyone’s life and they have been traded for times immemorial. However, the mechanism of commodity trading in India has changed with the passing time. In the olden times, commodities were traded physically, like buying and selling cattle, metals, spices, grains etc.

In that case, the physical deliveries of the commodities were made and the payments were also made physically. With the advent of technology, the face of commodity trading has drastically changed. Now, the commodities are traded online over the commodities exchanges. They are bought and sold in the dematerialised form and do not involve actual delivery.

The profit and loss settlements are made online and the balance is transferred to the trader’s account.

Commodity Trading Basics

After equity, real estate and precious metals like gold and silver, people have started investing in commodities too. It is the new avenue for the retail investors and traders to participate in.

Although commodity trading has its own risks and challenges, it is also a rewarding platform that helps the traders to make good profits in the process of buying and selling of commodities online. But just like other forms of trading, commodity trading also requires a lot of hard work, knowledge, experience and dedication. The traders must be well aware of the commodities, the markets and the world economy that causes the price fluctuations in the commodities.

The traders must also know and practice the fundamental analysis and/or technical analysis to be able to make the right moves in the commodity trading market. There are associated risks which, if not managed well, can lead to loss of capital.

The purpose of commodity trading is to diversify the portfolio.

With the diversification of the portfolio, the traders can increase their overall return by keeping the same level of risk which is a big thing in any form of trading. Basically, by entering into commodity trading in India, a trader is improving his asset allocation, hedging against risks like inflation and becoming a part of the global growth in demand.

In India, commodities are traded on Multi Commodity Exchange (MCX), National Commodities and Derivatives Exchange (NCDEX), National Multi Commodity Exchange, Indian Commodity Exchange, ACE Derivatives and Commodity Exchange and the Universal Commodity Exchange.

These exchanges are regulated by the Forwards Market Commission.

Commodity Trading Basic Premise

The basic premise of commodity trading is the mechanism of demand and supply.

When the supply goes low, the demand goes up and so do the prices and when the supply goes high, the demand goes down along with the prices. The traders take advantage of these price fluctuations to reap profits for themselves or to protect themselves from related risks.

The commodities for trading broadly fall into four categories: Metals, Energy, Livestock and Agricultural. The prices are also affected due to the change in demand and supply affected by seasons, government policies, social factors and global factors.

The trades are made in specific lot sizes and contract value for each commodity and each point movement in the price causes profit or loss.

Here is a small description of each of the categories of commodity trading:

Metals

This category primarily consists of the base and precious metals. Where base metals consist of Nickel, Steel, Zinc, Aluminium, Tin, Iron and so on, the precious metals are Platinum, Gold, Silver etc.

Energy

Energy commodities are obviously such that produce energy in form or the other. This could be electricity, petroleum products such as natural gas, coal, uranium, gasoline etc.

Livestock

Live Cattle, Poultry products primarily make up the livestock commodities for trading in India.

Agricultural

Finally, under agricultural commodities, there are corn, cotton, rubber, wool, coffee, wheat, sugar, soybeans etc.

For more information, check this detailed review on Top Commodities for Trading in India.

How Commodity Trading Works?

There are multiple ways by which a trader can involve him/herself into commodity trading in India. Here are the details:

Commodity Futures Trading:

The most popular way of trading commodities is through trading a commodity futures contract. The buyer and seller enter into an agreement to buy/sell a specific quantity of a specific commodity at a predetermined price at a later time. The entities entering into the commodity futures contract are mainly hedgers or speculators.

Hedgers are mainly importers, exporters or manufactures who enter into the futures contract to reduce their risks of financial loss due to change in the price of commodities at a later date.

For instance, airline industry enters into futures contracts for oil to ensure that they get oil at a fixed price in the future and are not affected by the market volatility.

On the other hand, the speculators are the ones who enter into futures contracts on commodities to take advantage of the price movements and make profits in the process. They mostly do not take actual deliveries and close their positions before the end of the contract.

Commodities as Stocks:

Commodity trading in India is also done in the form of buying and selling stocks of companies related to commodities.

For example, instead of buying actual oil contracts, the trader can buy stocks of the refineries or oil companies. Such stocks move in the same direction as the futures would, but they are easy to buy and hold and are less volatile comparatively.

The stocks definitely require more research and know-how. Instead of direct stocks, stock options can also be traded which require less investment and the risk is also limited to only the cost of the option. However, the drawback is that the stock options may not mirror the exact movements of the commodity in question.

Commodity Exchange Traded Funds (ETFs) and Exchange Traded Notes (ETNs):

ETFs and ETNs are other forms of commodity trading. Through them, the trader can invest in the commodities without directly investing in the futures contracts. ETFs and ETNs both mimic the price fluctuations in the actual commodity and trade like stocks.

The drawback can be that all the commodities do not have ETFs or ETNs associated with them and the reflection of price movements is not exact and point to point.

Commodity Mutual Funds and Index Funds:

Another indirect way fo commodity trading in India is to invest in mutual funds and index funds that invest in stocks of companies that are involved in commodity-related industries like energy, mining and agriculture. Some commodity index mutual funds also invest directly in futures contracts and commodity-linked derivatives and give a direct exposure.

They provide more diversification and liquidity but are not a pure play on the prices of commodities.

Commodity Trading Advantages

Commodity trading in India offers many advantages compared to other methods of trading. Mostly, investing in commodities provides benefits to investors at times of economic uncertainties. Some of the advantages are:

Diversification of the portfolio:

Commodity trading helps the traders to diversify their portfolio. By investing in commodities along with stocks, bonds and other methods, the trader is able to protect himself from a sudden fall in one of the asset classes. Also, commodities react differently to the economic and geopolitical factors than stocks, so investing in commodities helps to improve returns and reduce volatility.

Hedging:

Commodities act as an effective hedge against risks, specifically at the times of inflation or recession. If the price of the commodity is expected to go up, the trader can buy commodity futures and hedge against the risks of high prices. This is also useful for importers and exporters.

Protection against inflation:

When the economy starts to go down, inflation occurs and prices of commodities go up. At this time, the prices of stocks and bonds go down but investing in commodities can help the investors to benefit from the upswing and protect themselves from high commodity prices.

Lower margins:

The margin amount required for commodity trading is about 5-10% of the contract value which is quite less as compared to other asset classes. Therefore, the trader can trade more with less money.

Higher opportunities of growth and return:

Commodity trading in India is quite risky but if the risks are managed well and the investments are done right after proper research and analysis, it can turn out to be very rewarding and profitable. Also because of the rapidly increasing demand for the commodities, the commodity traders can grow and make good money.

Liquidity:

Investments in commodities are highly liquid as compared to investment in other asset classes like real estate and the buying and selling is very easy and quick so the positions can be squared off and cashed as and when required.

Commodity Trading Risks

Like all other forms of investment and trading, commodity trading is also subject to many risks. The risks get multiplied when the investor enters the market unprepared or with very high expectations. Caution has to be exercised and trading must be done according to one’s risk appetite.

Some of the risks are:

High leverage:

The margin amount required for commodity trading is quite less, thereby providing high leverage. However, high leverage may also act as a trap if not handled well. The trader has a high probability of losing the money that he does not own and thus be under huge debts.

High volatility:

Commodity, on the whole, is quite risky in terms of volatility. The volatility of commodities is almost twice that of stocks and four times that of bonds. Therefore, trading in commodity markets can be very risky for inexperienced traders.

Lack of Knowledge and Understanding:

The basis of any form is trading is knowledge and experience. Many new traders do not educate themselves and simply throw themselves into the sea of trading, unprepared. The traders must read good commodity trading books, talk and share experiences with other seasoned traders and make their own trading plans and strategies before they start practising trading.

Thus, commodity trading in India is an interesting and rewarding process which helps the investors in hedging, speculation and diversification of their portfolio.

At the same time, the market is quite volatile and risky, so the traders need to exercise caution before entering the market and must remain focused, dedicated and diligent to make good profits and reduce losses.

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