The basis of how commodity trading works is the concept of supply and demand.
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.
Getting it? It’s okay if you don’t. If you are a beginner, here are a few quick basics!
Commodity Trading is one of the most upcoming forms of trading in India. After equity, real estate and precious metals like gold and silver, people have started investing in some of the top 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 commodities online. But just like other forms of trading, commodity trading also requires a lot of hard work, knowledge, experience and dedication.
Just like some traders trade in stocks, some trade in commodities. These commodities can be energy, metals, agricultural products or livestock.
How Commodity Trading Works?
In order to understand how commodity trading works, it is of absolute importance for the traders to understand how the demand and supply work.
The supply of a commodity may get affected by various factors like the government policies regarding that commodity, economy of the country which is a big producer of the commodity, economic policies, political policies, health of the country, price of the raw materials, expected future price of the raw materials, cost of production, natural conditions, transport conditions etc.
Similarly, the demand is also affected by causes like weather, preferences of the customers, the income of the people, the price of the related goods like substitutes or complementary goods etc.
For example, the price of oil futures is affected by the political situation in the Middle East and the price of gold futures is affected by wedding season or the situation of gold mining companies.
Thus, the background to understand how commodity trading works is actually how demand and supply work. With inelastic demand and supply in the commodity markets, the prices become volatile and give the traders the opportunity to bank on the price fluctuations and earn money.
For example, a trader bought a Gold Futures contract with a minimum contract size of 100 gm at ₹72,000 on MCX. He pays the margin amount of, say, 3.5% which is equal to ₹2,520.
If the next day price of gold goes up to ₹73,000, the difference of ₹1000 will be credited to the trader’s account, and the next day if gold trades at ₹72,500, the difference of ₹500 will be debited from the account.
So, even by investing less money, the traders get an opportunity to make more profits using commodity trading.
With reference to the step by step process of how commodity trading works, it is more or less similar to all other forms of trading.
1. Opening a Commodity trading account and getting it approved:
The brokers also help in educating traders on commodity trading and in making sound financial decisions through their recommendations.
When the broker has been decided upon after due consideration, the paperwork is done. Application form which contains all the information like age, financial status, the trading experience of the trader is filled and submitted along with the required documents. The broker then analyses the documents and the form and upon satisfaction, the account is opened.
The trader also has to deposit the initial margin amount into the account as soon as the account is open. Initial margin amount is generally 5-10% of the contract value.
In addition to the initial margin, maintenance margin also needs to be maintained by the trader in his account, which will ensure that the trader is able to pay off in case he suffers any huge loss due to adverse price movements.
3. Order Processing:
Once the account is opened, it is good to go for placing orders on commodity trades. The trader studies the market using fundamental and technical indicators and decides to invest in a commodity. The trader informs the broker about the number of lots and contract value and deposits the margin money accordingly.
As soon as the order is filled by the broker, the contract is owned by the trader and is marked to market at the end of each trading day.
4. Mark-to-Market settlement:
At the end of each trading day, the clearinghouse determines the settlement price of each commodity. The settlement price is then compared to the price at which the order was placed and according to the movement in price, the difference is either credited to or debited from the trader’s account.
From the third day onwards, the comparison is made between the settlement price of that day and the previous day.
5. Termination of the contract:
The termination of a commodity contract can happen in many ways. This is important to understand how commodity trading works differently from other forms of trading. The contract can either be terminated by taking and giving delivery of the goods, which is actually a rare form of termination in the commodity market.
The most used method of termination of the contract is cash settlement; the difference in the expectation of the buying and selling parties is settled in cash. The commodity trade can also be closed by entering into a reverse trade by taking exact opposite position to the current position and thus netting the position.
As a bottom line, how commodity trading works is determined by how the prices of the commodities move, driven by the demand and supply. The process of trading is simple and uncomplicated, but it does involve high risks due to volatility and high leverage.
So, the traders must be cautious and well-informed before entering into the commodity trading market.
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