Want to trade commodities, here’s how
A right mix of commodities and equity in your portfolio can help you benefit from attractive returns, while reducing the risk component
The Indian investment market offers a lot of investment avenues. Most of us usually invest in bank fixed deposits, PPF (Public Provident Fund), recurring deposits, insurance, bonds, etc. A few of us—who are market savvy—also invest in shares. For those who want to diversify their portfolios beyond shares, commodities are one of the best options.
Commodities offer immense potential to become a separate asset class for market-savvy investors. Most investors consider investing in commodities as quite risky and complicated. But commodities are easy to understand as far as fundamentals of demand and supply are concerned. Retail investors should understand the risks and advantages of trading in commodities before making huge investments. Historically, pricing in commodities has been less volatile compared with equity and bonds, thus providing an efficient portfolio diversification option.
Brief history of commodity trading
The modern trade in commodity futures could trace its origins back to the 17th century in Osaka, Japan, there is evidence to suggest that a form of futures trading in commodities existed in China 6000 years earlier. Organized trading on an exchange started in 1848 with the establishment of the Chicago Board of Trade (CBOT).
The first milestone in the 125 years rich history of organized trading in commodities in India was the constitution of the Bombay Cotton Trade Association in the year 1875. India had a vibrant futures market in commodities till it was discontinued in the mid 1960's, due to war, natural calamities and the consequent shortages. The advent of economic liberalization helped the cause of laying emphasis on the importance of commodity trading. By the beginning of 2002, there were about 20 commodity exchanges in India, trading in 42 commodities, with a few commodities being traded internationally.
Commodities can be classified into five key sectors: Agriculture, metals and materials, precious metals, energy and services. Agri-commodity comprises of soybean, pepper, coriander, turmeric, etc; while bullion comprises gold and silver. Energy includes crude oil, natural gas, furnace oil and Brent crude among others, whereas metals consists of copper, lead, aluminum, zinc, nickel, etc.
Grains: Rice, Basmati rice, wheat, maize, jeera.
Oil and oilseeds: Castor seeds, soy seeds, castor oil, refined soy oil, soymeal, crude palm oil, groundnut oil, mustard seed, cottonseed, etc.
Spices: Pepper, red chilli, jeera, turmeric and cardamom.
Pulses: Chana, urad, yellow peas, tur dal.
Metals and materials
Base metals: Aluminum, copper, nickel, zinc, tin.
Bulk commodities: Iron ore, coking coal, bauxite, steel.
Others: Soda ash, chemicals, rare earth metals.
Precious metals and materials
Gold, silver, platinum and palladium.
Crude oil, natural gas, Brent crude, thermal coal, alternate energy.
Oil services, mining services and others.
Spot and future prices in commodities
Spot price is that price in the cash market where one buys and sells goods “on the spot”, while futures prices are prices of the same commodity at a future date.
For instance: If the spot price of gold is Rs. 14,700 per 10 gm today, the one-month futures price could be Rs. 14,800, whereas two-month futures price could be Rs. 14,950. The difference between spot and futures prices is the cost of carry i.e. interest cost, storing, insurance, etc. Generally futures prices are higher than spot prices.
At present, the regulator Forward Markets Commission allows futures trading in around 120 commodities. India has 22 commodity exchanges which have been set up under the overall control of Forward Markets Commission.
To trade in commodity futures, usually there the main exchanges—Universal Commodity Exchange, National Commodity and Derivative Exchange (NCDEX), Multi Commodity Exchange of India (MCX) and National Multi Commodity Exchange of India. All three have electronic trading and settlement systems and a national presence. As of now you will need only one bank account. You will need a separate commodity demat account from the National Securities Depository to trade on the NCDEX just like in stocks.
What is commodity futures contract?
A commodity futures contract is a commitment to make or accept delivery of a specified quantity and quality of a commodity during a specific month in the future date at a price agreed upon when the commitment is made. It is an agreement to buy or sell a set amount of a commodity at a certain time in the future at a certain price.
Commodity futures contract is a standardized contract set by a particular commodity futures exchange that includes the size (1,000 barrels, 5,000 bushels, 5,000 ounces, etc), the place where delivery can be made, the type and quality of the commodity to be delivered, and the price of the transaction.
Commodities traded in the commodity exchanges are required to be delivered at the contracted price, ignoring all the changes in the market prices. Commodity futures contract is one of the avenues for retail investors and traders to participate. Trading in commodity futures contracts can surely be very risky for the inexperienced. It is generally believed that most investors lose money in commodities’ futures. This happens only when market participants do not trade with discipline and fall victims to greed and fear.
How it works
When you buy futures, you don’t have to pay the entire amount, just a fixed percentage of the cost. This is known as the margin.
For example: You bought gold futures contract at Rs. 72,000 per 100 gm.
The margin for gold set by MCX is 3.5%. So you end up paying Rs. 2,520—also called margin.
The low margin means that you can buy futures representing a large amount of gold by paying only a fraction of the price.
The next day, the price of gold rose to Rs. 73,000 per 100 gm.
Rs 1,000 (Rs 73,000 - Rs 72,000) will be credited to your account.
The following day, the price dips to Rs. 72,500.
Rs. 500 will get debited from your account (Rs. 73,000 – Rs. 72,500).
Choose a broker
To trade in commodities, you need to select a broker. Several already-established equity brokers have sought membership with NCDEX and MCX and are already offering commodity futures services. Some of them also offer trading through the Internet just like the way they offer equities. You can also get a list of more members from the respective exchanges and decide upon the broker you want to choose from.
Transaction in commodity futures
A transaction in the commodity futures market is made electronically on the commodity exchange between brokers. The seller will have a broker, and buyer will have a broker. They will then transact an order for a purchase and sale. The buyers and sellers of commodity futures contracts have obligations. The buyer is obligated to take delivery and pay for the cash commodity during a specific time frame. The seller is obligated to deliver the commodity, for which he will be paid the price that was decided in the exchange pit by the brokers. (Sometimes the price can be more or less depending on the grade (quality) of the specific material.) The buyer and seller can eliminate their obligation by offsetting their trade at the exchange before the contract comes due. This is what most speculators do in the commodity markets.
How are the contracts settled?
All the exchanges have both systems—cash and delivery mechanisms. The choice is yours. If you want your contract to be cash settled, you have to indicate at the time of placing the order that you don't intend to deliver the item. If you plan to take or make delivery, you need to have the required warehouse receipts. The option to settle in cash or through delivery can be changed as many times as one wants till the last day of the expiry of the contract.
What you need to know?
A right mix of commodities and equity in your portfolio can help you benefit from attractive returns, while reducing the risk component. Go onto the commodities trading exchange—NCDEX and MCX—to see which commodities are offered for trading, their contract size and other criteria. You will have to get hold of a commodities broker to understand how trading works.
Daily financial newspapers carry spot prices and relevant news and articles on most commodities. Besides, there are specialized magazines on agricultural commodities and metals available for subscription. Brokers also provide research and analysis support. But the information easiest to access is from websites. Though many websites are subscription-based, a few also offer information for free. You can surf the web and narrow down you search.
Understanding concept of online commodity trading
Commodity trading is an investing strategy wherein goods are traded instead of stocks
Broadly speaking, commodity trading is an activity which involves investing/trading in commodities. It is similar to stock trading but instead of buying and selling shares of companies, a trader buys and sells commodities. Commodities traded are often goods of value, consistent in quality and produced in large volumes by different suppliers such as wheat, coffee and sugar. Trading is affected by supply and demand, thus, limited supply causes a price increase while excess supply causes a price decrease. Therefore, the process of commodity trading is directly or indirectly affected by the demand and supply in the market.
Commodity trading is an investing strategy wherein goods are traded instead of stocks. Commodities can be traded on a spot level or on the futures exchanges as futures contracts. A futures contract is an agreement between two parties to buy or sell an asset at a certain time in the future at a certain price. A commodity future contract is a future contract which has a commodity as underlying asset.
A commodities exchange is an exchange where various commodities and derivatives products are traded.If you take a look at a typical trading platform, you will see commodities listed as tradable contracts. Commodity trading is not limited to a particular exchange. Investors are free to trade on various exchanges if they desire to do so. An example of a commodity exchange where commodities are traded is the New York Mercantile Exchange (NYMEX), which is the world’s largest futures commodity exchange. There are 24 commodity exchanges in India. There are three national level commodity exchanges to trade in all permitted commodities. They are: Multi Commodity Exchange of India Ltd, National Commodity and Derivative Exchange, and National Multi Commodity Exchange of India.
Online Commodity Trading
Trading commodities online has gained popularity for many investors in recent years. Online commodity trading platform offers easy and convenient trading experience to investors. Trading commodities online also allows instant trading without having to contact a live broker to place your orders. Almost everything you could possibly need to trade commodities is available through an online commodity trading account including commodity trading charts, commodity news, and technical analysis programs. Online commodity trading gives you a sense of independence as a trader is in control of the trade and has to make end trading decisions. The execution of a trade is much quicker and not like the old times where you had to wait to call the broker and then give him the instructions about the trade, online trading is much convenient and results too can be seen instantly.
Advantages of online commodity trading
Convenient trading: Online commodity trading platform offers easy and convenient trading experience to investors. It provides high-end integrated trading applications for fast, efficient and reliable execution of trades. You virtually have everything you need when you log in to your trading account. Investors get access to a multitude of resources like live quotes, charts, futures news, research and even online assistances.
As a new trader, you will have access to all the research and trading facilities that are needed to help you execute your trades. You can decide what to buy or sell, when to buy or sell etc. either based on your own research or by referring to the research reports of your online commodity broker.
Flexibility: Online trading is nearly instantaneous, providing you the freedom to trade at your leisure from anywhere, anytime. This flexibility means you have the freedom of watching the market and making quick trades if needed. You don’t have to wait on anyone other than yourself.
Lower commissions: You can expect much quicker execution of your trades through an online broker as well as lower commissions. It is a lot cheaper to buy/sell one futures contract than to buy/sell the underlying instrument.
Liquidity: Another major benefit of online commodity trading is liquidity. Liquidity is characterized by a high level of trading activity. Assets that can be easily bought or sold are known as liquid assets. The involvement of speculators also means that futures contracts are reasonably liquid.
Leverage: Commodity trading also offers the benefit of leverage. Leverage means use of borrowed capital or margin to increase the potential return of investment. Only a small percentage of the total value of a position is needed to be paid upfront to get full benefit and to enhance profits.
Diversification: Commodity returns have historically had low or negative correlations with the returns of other major asset classes, and may be used to diversify a portfolio. Commodities may react differently from stocks and bonds in various economic and geo-political situations, enhancing risk-adjusted returns and reducing the overall volatility of a portfolio.
Geo-political events like wars and supply disruptions due to natural disasters like hurricanes, droughts and floods may impact the supply of, and increase the demand for, certain commodities. Including commodities in a portfolio may act as a potential hedge against certain types of event risks
Disadvantages of online commodity trading
While there are many benefits to trading commodities online, commodity investing online also has its disadvantages that investors should be forewarned. There are some hidden dangers that many novice traders overlook before they open an account to trade commodities online.
You need a mentor: With this lack of guidance, it is only natural to expect that many traders will be prone to repeating the same mistakes which eventually cost them their “risk capital.” Trading in commodities requires a trader to have firm knowledge of the factors that affect the demand and supply of a particular commodity. Usually in case of online trading, you don’t have someone to guide you with your trades. If you are new to commodity trading, then you may burn your fingers. Having an experienced broker with whom you can discuss trading strategies is likely to keep you out of trouble. Thus seeking an advice of a mentor is crucial if we want to improve our trading proficiency.
Leverage: Commodity futures operate on margin, meaning that to take a position only a small percentage of the total value needs to be available in cash in trading account. High leverage means high risk attached to the account. It acts as a double edge sword where benefit of low margin can result in poor money management.
Over trading: The third disadvantage of online trading relates to the issue of over trading. Online commodity trading can be risky if you are not disciplined. There is a tendency for a trader to deviate from his original trading strategy and switch to day trading after he gets bored of holding a market position for a considerable period of time. When this happens, it is similar to gambling in a casino.
In other words, without discipline, online commodity trading can burn a hole in your pocket. On the other hand, those who are well disciplined and have a sound trading plan, trading commodities normally through an online broker is the best way to go.
Different types of orders that can be placed
Limit order: It is an order where the user specifies the price at (or better than) which the trade should be executed.
Market order: It is an order which should be executed at whatever be the prevailing price on or after submission of such order. If there is no market at that point of time, it takes the last traded price and remains in the system.
Day order: It is an order which is available for execution during the current trading session until executed or cancelled. All day orders will get cancelled at the end of the day during which such orders were submitted.
Stop loss order: It is an order placed which is kept by the system in suspended mode and will be visible to the market only when the market price of the relevant commodity reaches or crossed a threshold price, which is called as trigger price as defined by the member. It is used as a tool to limit the loss.
Gold Savings Funds or Gold ETFs, what is a better option?
You may have been hearing all around that people are investing in gold and are advising you to do so too. However, buying physical gold is not the only option. Let us explore a Gold Savings fund and a Gold ETF and get acquainted with their features and differences. You can then gauge what would be a better investment option for you.
The main advantage about a Gold Savings Fund is that you can invest in it even if you do not hold a Dematerialized (Demat) account. You can even start a Systematic Investment Plan (SIP) with respect to this fund without a Demat account. Through an SIP, one invests a fixed amount at regular intervals, generally every month, into the fund. However, a Demat account is not required if one wishes to invest in a Gold ETF.
Gold Savings Fund
Gold Savings fund are very simple investments. It is simply a mutual fund that invests in their Gold ETFs. They even invest in some other short term funds. If the investor cannot constantly track his investment or is new to the investment world, it is a good option to invest in a systematic investment plan of Gold Savings fund. These funds do not directly invest in gold. The investment happens indirectly through Gold ETFs. However, as a Gold Savings fund invests through Gold ETFs, they have higher charges.
Gold Exchange Traded Fund
Gold Exchange Traded FundsorGold ETFs invest directly in Gold. The fund keeps an eye on daily gold prices and trade in physical gold to get the desired returns. Gold ETFs have their own high cost ratio which is the secret of the great investment results. The investments are electronic, i.e., one can invest in gold without actually holding it in physical form. However, one is required to have a Demat account to invest in a Gold ETF. Also, one cannot invest in it through an SIP, unlike Gold Savings Funds.
A Gold Savings fund offers you the option of SIPs which are suitable for those who want to invest in a regular and disciplined manner on a long term basis. Also, the need of a Demat account does not arise. However, they do not invest in gold directly and also have higher charges than Gold ETFs. If you do have your Demat account, Gold ETFs can be a better option as they will also cost you lesser than Gold Savings Funds.
Basics Commodity Trading
Commodities are actual, tangible products or goods which can be physically stored. Gold, cosmetics, books etc. are some of the examples for commodities. Investing in them with a commodity trading company is called commodity trading. Many investors make quick money from it by putting in any minimal capital they wish to invest.
1. Risk involvement
Some experts suggest that commodity trading is not for regular investors. It is risky to some extent but if you are careful and can control your greed, it can be safe enough and work for you like any other investment option. You need to determine your risk appetite and not directly aim for high returns in order to lower the risk.
2. The Process
In commodity trading, you do not actually own any commodity. The process is is to bet on the future price of a particular product depending on global and domestic demand-supply situation, weather, output etc. If you think that price of a product will rise in future, you can buy it now and sell when the price is high. When you think the price is going to go down then you may sell it. You would find buyers and sellers operating in the market any time. Non-fulfillment of the obligation results in the delivery of the commodity. While this is the process for futures trading, there is also spot market trading in the commodities market. Spot market trading involves farmers, traders etc. and results in the immediate delivery of goods in case of sales and purchases.
3. Types of players in this market
All those involved in a total commodity circle are called Commercials. This includes the basic producer, the developer and the merchants.
When a group of people pull together their investment to increasing the chance of good returns and cut back possible losses, they are called Large Speculators.
The most common players are Small Speculators. They are the individuals who invest through a broker or have their own commodity account.
4. Starting commodity trading
The first thing that you need for commodity trading is the knowledge of facts that affect commodities. All commodities have different reasons for their rise and fall. For eg., a crop which requires more rain will see its price rise in case of a drought as its supply may be affected adversely thereby making its supply scarce, but a crop which needs less rain will see its prices fall as the climate would favour its output, thus increasing its supply. You also need to be aware of the techniques of investing in this sector to get the best results. You need to ensure that you have a clear idea of a commodity and then sell or buy according to the expected market price and situation. You can invest through a commodity brokerage or operate a personal commodity trading account.
Hedging of Price Risk in Commodities
A person resident in India is permitted to enter into a contract in a commodity exchange or market outside India to hedge price risk in commodities imported / exported, domestic transactions, freight risk, etc. There are two channels through which residents can undertake hedge i.e. .Authorised Dealers' Delegated Route and Reserve Bank's Approval Route. With a view to achieving greater clarity on the rules / guidelines governing hedging of commodity price risk, clarifications on process and various operational issues relating to commodity hedging are given below:
Who can hedge?
A person resident in India, who has a commodity exposure and faces risks due to volatile commodity prices, can hedge the price risk in the International Commodity Exchanges/Markets, using hedging products, such as, futures and options, which are exchange traded and Over the Counter (OTC) derivatives as permitted by the Reserve Bank from time to time. Prior approval from the Reserve Bank / an authorised AD category - I bank is required.
What are the hedging facilities available to oil companies?
The Reserve Bank, through the approval/delegated routes, has permitted following facilities for oil price hedging:
a) Hedging of exposures arising from import of crude oil and export of petroleum products based on underlying contracts.
b) Hedging of exposures arising from import of crude oil based on past performance up to 50 per cent of the volume of actual imports during the previous year or 50 per cent of the average volume of imports during the previous three financial years, whichever is higher.
c) Hedging of inventory up to 50 per cent of the volumes in the quarter preceding the previous quarter.
d) Hedging of exposures arising from domestic purchase of crude and sale of petro products on the basis of underlying contracts.
e) Hedging of exposures on import / export of jet fuel and domestic purchase of jet fuel by users i.e., domestic airline companies.
Which are the entities permitted to hedge oil price risk?
Domestic oil refining and marketing companies are permitted to hedge their price risk on crude oil and petroleum products on overseas exchanges/ markets to modulate the impact of adverse price fluctuations. Domestic users of aviation turbine fuel (ATF) are also permitted to hedge their price risk on ATF in overseas exchanges / OTC markets.
What are the commodities, other than petroleum and petroleum products, purchased domestically which could be hedged in international exchanges?
The Reserve Bank has permitted companies listed on a recognised Stock Exchange to hedge the price risk in respect of domestic purchases and sales of aluminium, copper, lead, nickel and zinc under the delegated route. The eligible company interested in hedging price risk in respect of above commodities may apply to an AD Category-I bank authorized by Reserve Bank for such hedging.
What are the hedging facilities permitted for entities in Special Economic Zones (SEZs)? \
Authorized Dealer Category I banks are permitted to allow entities in Special Economic Zones to undertake hedging transactions in the overseas commodity exchanges/markets to hedge their commodity price risk on import/export. Separate Reserve Bank approval is not necessary in this regard. Such transactions are permitted only when the unit in the SEZ is completely isolated from financial contacts with its parent or subsidiary in the mainland or within the SEZs as far as import/export transactions are concerned.
What is a freight derivative?
A freight derivative is a financial instrument whose value is derived on the future levels of freight rates, such as "dry bulk" carrying rates and oil tanker rates. Freight derivatives are used mainly by end users such as ship owners and large ware houses, suppliers such as oil refining and marketing companies to manage risk and hedge against price volatility in the supply chain.
Which are the entities permitted by RBI to hedge freight risk?
Oil refining and marketing companies, shipping companies and other companies which have substantial overheads on account of freight component, are permitted to hedge the freight risk in international exchanges/OTC markets on the basis of the underlying exposures. The oil and shipping companies are permitted to hedge through the delegated route i.e. through AD Category I banks and other corporates having freight exposures are permitted to hedge after obtaining prior approval from the Reserve Bank.
Basics of Trading in Commodities
There is a surging interest among investors in commodities, which as an asset class can provide opportunities to fine-tune a portfolio’s risk and return characteristics. The commodities asset class has experienced strong growth in recent years. The low historical correlation to financial assets, equity-like returns and risk characteristics of commodities provide investors a means to diversify their portfolios.
Commodities and futures: Commodities include goods used in the initial phase of the manufacturing process and are real assets such as energy, industrial and precious metals, agriculture, and livestock. Meanwhile, futures are contracts of commodities that are traded at a futures exchange.
However, futures contracts have expanded beyond just commodities and transactions now include futures contracts on financial markets, currencies and many others.
Commodities futures contract: This is a standardized contract set by a particular futures exchange that includes the size in barrels, bushels or tonnes, the place for deliveries, the type and quality of the commodity to be delivered as well as the transaction price. The futures contract is negotiated on a regulated futures exchange where all buy and sell orders are routed to a single location on the exchange.
Commodities trading: Brokers who are members of that exchange engage in transactions on whatever commodity is being traded on. Both seller and buyer have their respective brokers for transacting an order for a purchase and sale. Further, both buyer and seller enter into obligations.
The former is obliged to take delivery and pay for the commodity in cash within a specific timeframe, while the seller is obliged to deliver the commodity for the price that had been ascertained when the contract was signed. The buyer and seller can also absolve themselves of the obligation by offsetting their trade before the contract expires.
Commodities trading in India: A capital as low as Rs 5,000 is enough to begin trading. The money goes to margins payable upfront to exchanges through brokers. The margins range from 5-10% of the value of the commodity contract. The exchanges are regulated by the Forward Markets Commission and unlike the equity markets, brokers need not register with the regulator.
What you should know about inflation
With all the buzz surrounding inflation these days, one must understand it and its effects on the economy. Simply put, inflation is the rise in prices of the various products and services that we avail. Companies increase the prices of their products and services if the cost of their resources, or input costs, increase. Rising prices affect businesses and individuals alike and every business tries to pass on the price rise to customers to cope up with the situation.
A thought for investors
If you are a regular investor, you will understand the bearing inflation has on investments. New investors must be acquainted with the effects inflation can have on the market. You will need to change your investment strategies accordingly to make sure that you beat the rate of inflation. While investing, assume a rate of inflation accordingly to the level it is at present. When you are calculating your returns, you must make sure that the rate of your returns beats the rate of inflation. For example, if the rate of inflation in a year is expected at 7% and your investment which matures then has a rate of interest at 8%, you are effectively beating inflation.
Financial statement of companies
The financial statements of companies are an important gauge for understanding inflation. The financial statement of a company includes theirs gains, asset value, expenses and even the past expenses. This way, you can calculate the difference between the margins, expenditure and income between then and now. The current situation of a company, and its future, becomes clear with the financial statement.
The market situation
When inflation is on the rise, retail product prices increase. Once you have seen the company’s financial statement, you will get a clear idea about the effect that will have on the prices of the company’s products and services.
Change in interest rates
Typically, the Reserve Bank of India changes interest rates depending on inflation levels. When inflation is high, banks encourage people to save more money. At this time, bank deposit rates are high and loans are expensive. When inflation is low, banks do the opposite to boost demand and growth.
Best time for investors
A rising inflation scenario is the best time for investors. They can park their money is gold as the metal is considered as a hedge against inflation. Gold prices appreciate even when inflation rises. As mentioned earlier, investors can also park their funds in bank fixed deposits etc. as interest rates are typically high in a rising inflation scenario. However, when it comes to stocks, factors other than inflation also need to be considered before investing.
Courtesy : Financial Literacy Agenda for Mass Empowerment(FLAME)