Commodity trading is the act of investing in raw commodities which function as inputs for the economy and industry. The investors looking to start commodity trading must remember that unlike trading in stocks or bonds of companies, the choice here is to buy and sell actual commodities such as pulses or gold and make gains on that.
Hence, commodity trading can serve as a good differentiator and a diversification option for one’s portfolio if they remember to know the market well and make calculated decisions.
Basics of the commodity market
In India, commodity trading is governed by the Securities and Exchange Board of India since 2015 when the commodities market regulator Forward Markets Commission merged with it. Under SEBI, there are more than 20 exchanges offering investors the option of trading in commodities.
To start commodity trading, one needs to open a Demat account with the National Securities Depository Limited (NSDL). The Demat account functions as a holding account for all your investments in a ‘dematerialised’ or electronic state. The Demat account can then be used through a broker to invest in commodities at any commodities exchange.
The major exchanges functional in India right now are:
- National Commodityand Derivatives Exchange – NCDEX
- Ace Derivatives Exchange – ACE
- Indian CommodityExchange – ICEX
- National Multi CommodityExchange – NMCE
- The Universal CommodityExchange – UCX
- Multi CommodityExchange – MCX
Currently, many investors don’t trade in commodities but that is soon changing as the awareness is rising in the market.
How to trade
An investor can trade in any number of commodities on the commodity markets. There are innumerable options across various sectors. While most people think of just gold and silver as commodities worth trading on the market, there are options ranging from renewable energy to mining services. It is important for an investor to know these commodity trading options as they provide the right amount of diversification and investment avenues to make short-term and long-term gains.
The categories of available commodities are split as the following:
- Agriculture: grains, pulses such as corn, rice, wheat etc
- Precious metals: gold, palladium, silver and platinum etc
- Energy: crude oil, Brent Crude and renewable energy etc
- Metals and minerals: aluminium, iron ore, soda ash etc
- Services: energy services, mining services etc
Just like shares of firms, these commodities are traded on exchanges with prices going up and down throughout the day based on the demand and supply. The current price of a certain quantity of a commodity is called a spot price. It is important to remember that commodities are often sold in lots which means that one must buy a minimum amount of a commodity and then in multiples thereafter.
Commodity trading instruments
Once you have decided to trade in certain commodities, you must know the various instruments available for you to make the investment. The best way to invest in commodities is through a special instrument called a commodity future. It is a contract under which a commodity is agreed to be exchanged between a buyer and seller at a certain pre-decided date in the future at an agreed-upon price. The price and date of the contract are fixed and can’t be changed later.
Now, the investor who has decided to buy the future tracks the prices of the commodity in the open market and the direction of the prices determines his gain from the futures contract that he has bought.
Let’s illustrate this with an example.
For instance, silver could be priced at Rs 60,000 per kilogram on a commodities exchange when you decide to invest in it through a futures contract. You find a futures contract expiring after 30 days which is priced at Rs 62,000. Now, you can buy this contract by paying a part of the value of the contract. This portion you pay is called a margin and it allows you to have a larger exposure of the commodities by paying very little.
Once you have paid the margin, you have agreed to buy a kilogram of silver at Rs 62,000 from the seller after a month, irrespective of its market price.
Now, if the silver price in the market is Rs 65,000 per kilogram, you will have made Rs 3,000 profit per kilo of silver. This is your gain from the futures contract and it will be credited to your account.
Types of contracts
It is important for an investor to remember that commodity contracts are of two kinds:
- Cash-settled future contracts and
- Delivery based contracts
The delivery-based futures require the seller to produce warehouse receipts as the actual delivery of the commodities takes place once the futures contract expires on the pre-agreed date. Cash-settlement contracts, meanwhile, only settle gains/losses depending on the price of the commodity.
Investors can indicate which kind of settlement they would prefer while entering into a futures contract but they must keep in mind that the settlement type can’t be changed once the contract has expired.
Getting started in commodities trading can be a good means for an investor to diversify their portfolio and also get good returns since commodities see relatively less price volatility compared to shares and other capital market instruments.