Beginner’s guide to commodity trading

Hareesh V

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Commodity futures transactions involve trading in futures or options contracts of physical commodities that are listed on the recognised commodity exchanges. Commodity exchanges and commodity trading have been in existence for decades. They help efficient price discovery and provide a hedging tool to farmers, traders and consuming industries. They also provide the basis for settlement of physical contracts as well as a robust mechanism for physical delivery of commodities, if required.

Commodity contracts are similar to equity contracts with fixed expiry dates, standardisation of quality specifications and risk management parameters. There can be some minor changes in contracts of the same commodity for e.g. there is 1-kg gold contract and gold mini contract (100gm) on MCX. Both buyers and sellers of the futures contract are required to provide the margins for trading and also settle price fluctuations on a day-to-day basis.

As commodity contracts are available for up to six months, the farmers can benchmark the price of their physical stock against the futures price and reap benefits. At the same time, consumers, who are buyers of these commodities, can also lock in their prices for the forward months and thus, insulate themselves from any increase in the prices closer to their actual consumption of the material. The prices on the exchange are thus determined on the basis of factors such as demand and supply, weather, geopolitical concerns in commodities such as crude oil etc, economic factors in commodities such as gold which is sensitive to currency and interest rates, and government policies such as export and import duties etc.

Who can trade futures

Individuals, high net worth individuals (HNIs), corporates, hedgers, processors and other people related to physical markets can trade in commodities. Internationally, the classification of clients is on the basis of commercials (who are hedging customers) and non-commercials who are speculative — trading type of clients.

What is being traded 

Commodities that are being traded in Indian markets can be categorised under the following heads:

Precious metals – Gold, silver

Base metals – Copper, nickel, zinc, lead, aluminium

Energy – Crude oil, natural gas

Softs – Sugar, cotton

Edible oil complex – CPO, soybean, soyoil, mustard seed, castor seed

Pulses – Chana

Spices – Turmeric, chilli, jeera, dhanya, cardamom

Grains – Maize, wheat

Others – Mentha oil, guar seed, rubber

Present scenario 

Since their peak in 2011-12, precious metals such as gold and silver have seen a 30-60 per cent correction in the prices. However, it was post an unprecedented run up in prices from 2004 to 2011 where prices in gold went up from $400 to $1,900 and silver from $6 to $50. The downtrend witnessed in the commodities sector was mainly due to strengthening dollar, booming equity market and feeble demand from the world’s top commodity consumer China. Meanwhile, in domestic market, the introduction of the commodity transaction tax, lack of volatility in commodity prices and non-availability of new products influenced sentiments.

Anyhow, most of the commodities are on the recovery track recently. Gold prices in the key London spot market recovered from a five-low year of $1045.85 an ounce. A drop in US dollar has burnished gold’s safe haven appeal. The postponement of US interest rate hike influenced the US currency, sending the dollar index to a six-month low. 

Silver too gained. Crude oil price is also on the gaining path. After posting a low of $26.05, the level last seen since 2003, oil prices gained momentum and are currently trading near of $44 a barrel. Surplus production from the top producing countries was the key reason for the early drastic sell off in crude oil. The healthy recovery was seen in a few base metals nowadays as well.

Action taken from the new commodity regulator SEBI is giving more confidence to the trading community. The earlier commodity futures watchdog Forward Market Commission (FMC) has been replaced by SEBI since September last year.  

Reports say SEBI will introduce more products and launch a new price-pooling mechanism in agricultural commodities. Also, moves to attract more hedgers and possibilities of introduction of ‘Options’ and ‘Index Futures’ in this platform will increase liquidity and higher participation in the commodity derivative segment.

The author is Head of Research, Geofin Comtrade. The views expressed in this article are his own.