Products or goods like food, metals, energy are known as commodities. They are things we use in our daily lives and are tradable in nature. Hence, commodities can be bought and sold freely. The four main types of commodities are as follows:
- Metals like copper, gold, silver, and platinum.
- Energy like gasoline, heating gas, crude oil, and other forms.
- Agriculture like cocoa, wheat, rice, and ragi, etc.
- Livestock and meat such as cattle and eggs, etc.
Since ancient times, commodity trading has been happening in India. However, as a result of poor government policies, foreign invasions, and fragmented markets, it somewhat reduced in its popularity. With the introduction of stock market exchanges like NCDEX and MCX commodity trading in India regained some of its significance and popularity.
Advantages of Commodity Trading
Online commodity trading comes with many pros. Some of these are as follows:
Protection against inflation
With the increase in demand for goods and services, an increase in the price of goods themselves, as well as the commodities that make up their raw material. In this environment, interest rates increase, which thereby increases the cost of borrowing as well as subsequently reducing the net income of the company. A drop in the income of the company can also affect the profits that are shared amongst shareholders.
Hence, during inflation, the stock prices in the market drop. In contrast, the price of commodities that are required in the manufacturing of finished goods can substantially rise as it is seeing a growth in demand. Ultimately, the rising prices of final goods that are inflated are correlated with the price of the commodities that made them. Hence, investors often flee to commodity futures so they can protect their capital from the impact of inflation while maintaining their value.
Hedge against political tensions
Another hedge that commodities provide investors is that against geopolitical tensions. Any geopolitical event such as riots, wars, or conflict can instantly disrupt the supply chain that results in a scarcity of resources. It becomes quite difficult to not only procure but also transfer one’s goods. A commodity online must have a physical counterpart that will be bought and sold by the investor. The raw materials that will be transferred and produced into finished goods are disrupted in their supply chain as a result of geopolitical tension.
Due to the supply and demand mismatch, the prices of commodities can rise exponentially. In these events, there is strong pessimism within the market that causes stock prices to fall drastically. This is also why investing in commodities can aid in stemming losses that one sees in one investment portfolio.
Facility for high leverage
Futures, options, and other commodities derivatives provide an exceptionally high amount of leverage. You have the option to easily control a large position by paying only about 5% or 10% of the contract value as an upfront margin. Any move in the prices of commodities online that is considered insignificant can result in gains that are exponential. Therefore, margin trading creates the possibility to garner humongous returns with the aid of leverage in online commodity trading. The minimum amount of margin necessary for trading commodity futures might vary but it is a lot lower than that for stocks. For instance, you are only required to place about 23/5 of the total value of the trade as your initial margin for trading wheat futures.
Disadvantages of Commodity Trading
Commodity trading is a double-edged sword, as with most stock market instruments. Some of its cons are as follows:
That’s right. Leverage can be a great thing, but also a terrible one. In short, it can help you in controlling a huge position with little capital upfront. If your initial margin requirement is 5%, then you have the opportunity to buy commodity futures worth ₹1,00,000 for just ₹5000. Even a slight change in the price of your contract will then have a huge impact on your losses or gains. If the price were to fall by as little as ₹10, you can instantly lose₹10,000, since the lot size is 100 with 1000 contracts being purchased. Low margin requirements also encourage an excessive amount of risk, which can wipe out your entire investment.
Prices of commodities are quite volatile and rely strongly on supply and demand factors. Both the supply as well as the demand for commodities are elastic in price. An inelasticity in price means that while these prices may increase or decrease, the supply of the commodity remains unchanged. As an example, consider the fact that if one were to increase commodity production by growing new crops, extracting iron from deposits of iron ores underground, or extract natural gas, this would require a copious amount of time. All the same, as commodities are pre-requisites to our daily lives, price changes will seemingly not affect their demand since they are essential commodities, and consumers are habituated to them, thereby preventing them from looking at alternative means.
Not diversification friendly
The typical thought is that there is a low to a negative correlation between the prices of stocks and those of commodities. As explained earlier, when stock prices are tumbling, commodity prices about shoot skywards. However, this theory or assumption did not hold true during the 2008 financial crisis, when the prices of commodities like gas and oil fell drastically along with stocks. In the financial crisis that ensued in 2008, there was a drop in the overall demand for commodities which resulted in large-scale unemployment, which further halted production.
The Bottom Line
Trading commodities is a lucrative investment option that can help you grow your wealth, but keep in mind that it comes with its set of rules and regulations. Commodity trading gives you the option to leverage your gains but it can also leverage losses if you are not careful enough. Due to the high volatility, commodities offer much better returns, but they are not diversification friendly. Hence, it is important to be adequately prepared with one’s portfolio and research before jumping into the world of online commodity trading.