Overview

Although equity markets reign supreme in India, commodity and currency markets are emerging as lucrative trading options for the resolute trader. Commodity and currency trading both present alternative asset classes for investment, and, in addition to stocks, they can help in diversifying investors’ portfolios.

Unlike stocks that are driven by fundamentals, commodities and forex markets are dictated by macro-economic factors that cause demand and supply, trade and geopolitics. Moreover, commodities and currency are global markets, which lend investors insight into international affairs.

What is currency trading?

Currency trading, foreign exchange or forex is the exchange of international currencies in pairs. In India, stock exchanges such as the National Stock Exchange (NSE), Bombay Stock Exchange (BSE), United Stock Exchange (USE) and MCX-SX provide the marketplace for the sale and purchase of currencies. Worldwide, forex is the largest market, although only a small number of currency pairs drive the volume of trading.

Commercial banks, central banks, corporates, forex brokers, investment management firms, hedge funds and retail investors participate in currency trading. For trading in this market, investors need not open a Demat account. Only a trading account with a broker will suffice since cash or equity, used by the stock market, are not used in currency trading. The forex market operates only between 9:00 am and 5:00 pm, and investors can trade only in the futures and options segments.

How currency trading works

Pairs

Unlike other markets where a single security, stock or commodity is traded, in currency markets trading takes place in pairs. This means that you have to buy one currency and sell the other for each transaction. These pairs are expressed as (currency 1/currency 2), where currency 1 is the base currency and currency 1 is the quote currency.

In India, currency trading is allowed in these pairs: (USD/INR), (EUR/INR), (JPY/INR), (GBP/INR), (EUR/USD), (GBP/USD) and (USD/JPY). The major pairs, which almost always involve the US dollar, are (USD/EUR), (USD/CAD) and (USD/GBP). Pairs that do not involve the US dollar are called minor pairs. Exotic pairs are those where one currency is major and the other is minor.

Pips

Pip stands for percentage in point, or price interest point and is the smallest change in the valuation of a currency pair. It is one-hundredth of one percent, or the fourth decimal place. It is used to determine gains or losses upon the trading of a currency pair.

Future derivatives

Forex trade in India takes place through currency derivatives such as futures contracts, forex spots and forwards. Futures contracts mention the date, quantity and price at which currencies will be traded in the future. This method is used in the forex market instead of physically exchanging the currencies to trade.

Factors affecting currencies

The demand and supply of a particular currency, interest rates, geopolitical tensions, policy changes, and economic data are some of the factors that affect the forex market.

Benefits of forex trading

Trading in forex market is highly transparent because the information about the movement of currencies is readily available.

– Transaction costs of trading in the forex market are low, thereby giving traders a chance to earn higher profits.

– With no minimum capital, you can avail of leverage of up to 100 times your investment from your brokers against which to trade.

– Your profits will depend on your strategy rather than on fundamental analysis, as is the case with trading stocks.

Disadvantages

– Forex markets, dependent on elections and geopolitical tensions, are highly volatile and difficult to predict. Small adverse changes in pip can result in massive losses.

– Seeking high leverages can also lead to losses based on the risk involved and management of your finances.

– The global currency market is poorly regulated. Dominated by brokers and banks, it can give way to price manipulations and scams.

What is commodity trading?

Metals, spices, pulses, coffee and crude oil are among a long list of items traded in the commodities market. Commodity trading is used as a tool to diversify traders’ portfolios, especially in the face of inflation.

Commodity markets in India date back to 1875 when the Bombay Cotton Trade Association was established to facilitate cotton trading. The market suspended operations in the 1960s, but was reintroduced in the 1990s. Now, there are 22 exchanges under the Forward Markets Commission that facilitate the trade of commodities. These include the Indian Commodity Exchange (ICEX), Multi Commodity Exchange of India (MCX), National Commodity and Derivative Exchange (NCDEX), National Multi Commodity Exchange of India (NMCE).

How commodity trading works

Types of commodities

The commodities traded in the market can roughly be placed in four categories – energy, agricultural produce, metals and bullion. Natural gas, crude oil, gasoline and heating oil are included in energy. The prices of these products are influenced by economic developments and supply of oil from the biggest wells around the world. Investors should track developments in OPEC, alternative energy, and economic pitfalls.

Sugar, cotton, coffee, cocoa, soybeans, black pepper, castor seeds and cardamom are among agricultural produce in which traders invest. Bullion refers to precious metals such as gold, silver and platinum. Other metals such as copper, lead, zinc and nickel are also traded on the commodities market.

Futures contract

The most common method of investing in commodities is through the use of futures contracts. Under this, traders legally agree to buy or sell a particular commodity at a set price on a specified future date. Futures contracts allow trading without having to pay the entire price of the commodity, but only a fraction. This is a percentage of the original market price, and lets traders buy a futures contract valued at a large amount at only a small portion of the total cost.

Types of players

The most dominant players in the commodities market are hedgers and speculators. Hedgers are producers of commodities who enter the market to reduce their risks by entering a futures contract. They can sell their futures contract and make a profit if the price of their commodity falls in the market. Alternatively, if the price of the commodity rises, the manufacturer can sell the produce at a higher price in the local market.

On the other hand, speculators are traders who try to predict the price of the commodities to make profits. A large group of people can also come together to reduce risks and maximise gains. If speculators feel the price of a commodity will rise, they buy futures contracts and sell them when the price eventually increases.

Benefits

– Commodities tend to go in the opposite direction of stocks and forex, making them a good tool of portfolio diversification.

– Exporters can hedge their risks because of futures contracts prevalent in commodities markets. They can substitute their purchases until the time is ideal for purchasing in the market.

– As opposed to equity, commodities make for an attractive investment during inflation. This is because prices of goods and services rise because of inflation, leading to a rise in costs of raw materials which are traded on the commodities market.

Drawbacks

– Even though commodities ensure portfolio diversification, the fact that they tend to belong to a few concentrated industries limits the overall diversification of assets.

– Commodity prices are highly volatile, which presents the risk of major shifts in prices.

– According to past trends, during higher volatility, commodities led to smaller long-term returns when compared to stocks.

Conclusion

The choice between investing in forex or commodities markets is affected by the limitations of individual investors, or the overall milieu of each market. It can simply be a matter of personal choice or depend on the differences in regulations of each market. The advantages and drawbacks of leveraging in each market can also inform the choice of investors. Moreover, the limitations of the exchange such as over-the-counter trading or brokerage also play a key role in the choice investors make.