Can investing in commodities act as a hedge against risk? Can the grains to bullions reap you profits? How does commodity trading work? If you are a newbie to commodity trading, this article will help you understand all the above-stated questions. Scroll through and learn all you need to know about commodities trading.
What are Commodities?
Commodities are assets or goods that are exchangeable in nature. These are the goods or resources of essential value that can be turned into refined goods. It can be energy resources, metals or raw food resources.
Commodities are of two kinds in the market. One is hard commodities the second one is soft commodities. Hard commodities are extracted or mined. For example: resources like metal ores, gold, rubber and oil reserves. These are resources that can be used to make other goods or services. Soft commodities are agricultural products or livestock. For example: corn, wheat, coffee, sugar, soybeans, etc.
What is Commodity Trading?
The question that comes naturally, is why are these commodities traded at all? Let’s take an example of hard commodities. Hard commodities make up the foundation of the economic health of the country. The demand for these can become the barometer to measure the future economic stability of the country.
Similar is the case with soft commodities. Its production and shelf life depend on the environmental conditions of the country. Some crops can depress the prices. This can lead to a surplus in the market.
Commodity trading is done via on-the-spot markets or exchanges. There are minimum standards set by the exchanges, to be able to trade commodities. Traders buy and sell commodities through financial instruments like derivatives i.e. futures and options and or on the spot market. Commodity trading offers its investors to expand their financial portfolio beyond conventional financial securities.
An investor buys and sells commodities similar to equity or shares. One can buy the commodities, wait for the price appreciation and sell them in future when the target is hit. The seller on the other end, sells the commodities when they expect no appreciation of price for the future.
Types of Commodities
We already discussed the types of commodity markets. One is the spot market or the cash market where the exchange of physical commodities takes place for immediate delivery. The other is the derivative market is based on the value of an underlying asset. On the expiry of the contract, its delivery is made in future based on the price agreed upon in the present. Now, let’s know about the basic types of commodities that are traded in the commodity market.
Energy
Energy resources like Natural gas and oil are a part of commodity trading in India. But in other countries like the USA, and Canada trade uranium, coal, ethanol and electricity. These commodities are used in households and industries and are traded in bulk.
Metals
Metals which are used in construction, and manufacturing like iron, zinc aluminium, lead, copper, nickel, brass and other base metals are traded in commodity trading. Precious metals like gold, silver, and platinum are also standard commodities.
Agricultural Commodities
There is a wide spectrum of agricultural goods that are traded in commodity markets. In India, commodities like sugar, oil seeds, cereals and pulses like maize, barley, wheat, chana, moong, basmati rice; fibres, and spices like black pepper and cardamom are traded.
Environmental Commodities
The energy goods like emission allowances, biofuels, biogas, renewable energy certificates, and carbon offsets are tradable instruments in commodity trading.
How To Start Trading in Commodities?
Commodity trading is now gaining as much popularity as equity and derivative trading. Investors are trying out their hands in speculating as well as hedging risk, as one can trade on lower margins. Commodities tend to have a little or negative correlation to equity and stocks. Because of this, the commodities help you diversify your portfolio.
So, if you want to expand your financial portfolio using commodity trading, let’s understand how to start trading in commodities. The primary thing that one should do as a beginner in commodity trading is to know in-depth about all the exchanges that commodities are familiar with.
The very first step to take is to complete the basic KYC and open the trading account. Here’s where an authentic broker like Value4Money can assist you. As you know, for equity you need to open a demat account. In the same way, for commodity trading, you need a separate trading account and a demat account.
Trading commodities involves maintaining margin money, mark-to-market settlements and effective delivery. The ticket size and trade value are comparatively high in the commodity market. The investor must maintain an initial margin before executing the trade. Somewhere between 5-10% of the total contract value.
The investor then places the order to the broker and conveys the number of lots and the contract value. Also, the investor needs to provide a maintenance margin. In case of loss and adversity due to unexpected market volatility. This allows the broker to take a call using the maintenance margin if necessary.
The clearing house at the end of the day publishes each commodity’s settlement price. At the end of the trading day, the difference between the contract’s settlement price and purchase price comes to a settlement. This phenomenon is called mark-to-market.
Different Ways to Trade in Commodities
Trading in commodities is different, when you compare it with trading in equities. Learn the different ways to trade in commodities, to get a better understanding of it before you start.
Direct Investment
One of the ways to invest and trade in commodities is to directly purchase them. Investors gain physical ownership of it. When you directly invest in commodities like gold or silver it involves a high transaction cost. They become physical assets of value. Investors of such commodities as precious metals have to sell them in a particular time frame because of the limited shelf-life. Other issues are its storage, liquidity and insurance.
Purchasing Stocks
Using a stock screener, individuals find companies to invest in individual securities. Mining and energy sectors are where investors watch out for and choose from the listing. There are chances that you can make a profit, even if the commodity is not performing well. If you purchase a stock of a well-established company, you will have chances to grow profits even if the price of a commodity like energy goes down.
The reason why you can make profits is the company’s sound foundation and fundamentals.
Commodity ETFs (Exchange Traded Funds) and Mutual Funds
There is a range of Commodity ETFs that one can invest in. It remains specific to individual commodities. For example, if you want to buy a silver ETF, to gain exposure or a gold ETF. Unlike direct investments, there are no purity or storage issues in ETFs, as the possession is electronic, through a demat account.
You can trade in a specific commodity through commodity mutual funds. The funds are derived from the value of the underlying commodities. For example, the trading price of coal, petroleum or metals. The various types of commodity funds are true funds, index funds, and natural resources funds. The funds vary with the fluctuation in market movements. You should consider investing in such mutual funds mindfully only if the potential to bear the risks is within your tolerance limits.
What is the status of the industry in India?
In India, the commodity market was legally established in 2003. Now in 2023, there are three main commodity exchanges that allow transactions in commodity exchanges. The Multi Commodity Exchange (MCX), National Commodity And Derivatives Exchange (NCDEX), and Indian Commodity Exchange (ICEX).
The daily turnover of MCX is the highest in both spot and derivatives trading. Commodity trading has garnered a special place in driving economic growth in the country.
