The stock market is not the only financial market where one can trade. Just as popular is the commodities market where physical goods (commodities like bullion, metals, etc.) are exchanged.
In this article, we will discuss about the marketplace of commodities trading. We’ll also delve into the benefits, limitations and types of commodities contracts.
What is the Commodity Market?
A commodity market is where investors trade in commodities like precious metals, crude oil, natural gas, energy, and spices, among others. Investors seeking diversification in their portfolio can explore commodities as an alternative to conventional investment avenues. This helps reduce risk and protects against rising prices in an economy.
There are five types of commodities:
- Bullion: Gold, Silver
- Metals: Aluminum, Brass, Copper, Lead, Nickel, Zinc.
- Energy: Crude oil, Natural Gas.
- Agricultural commodities: Black pepper, Cardamom, Castor seed, Cotton, Crude palm oil, Mentha oil, Palmolein, Rubber.
- Live Stock: Live Cattle, Pork, and Feeder Cattle.
Commodity Exchanges in India
India has 22 commodity exchanges that have been set up under the Forward Markets Commission. The following commodity exchanges are popular choices for trading in India-
- Multi Commodity Exchange of India (MCX)
- Indian Commodity Exchange (ICEX)
- National Multi Commodity Exchange of India (NMCE)
- National Commodity and Derivative Exchange (NCDEX)
How Does aCommodity MarketWork?
Suppose you bought a gold futures contract on MCX at ₹72,000 for every 100 gm. Gold’s margin is 3.5% on MCX. So, you will be paying ₹2,520 for your gold. Suppose that the following day, the cost of gold increases to ₹73,000 per 100 gm. ₹1,000 will be credited to the bank account you have linked to the commodity market. Assume that the day after, it drops to ₹72,500. Accordingly, ₹500 will be debited from your bank account.
How To Trade Commodities?
Investors can engage in commodity market investment using futures or options contracts. A futures contract requires individuals to agree to deliver a product at a later date for a set price, while an options contract is an agreement without the same level of obligation.
Futures Contracts
In futures contracts, sellers make agreements with buyers through brokers to buy a specified quantity of products at a predetermined price. If market prices decrease, sellers can make margin profits, and if prices rise, buyers or brokers can profit.
These trades are either overseen by a commodity exchange, known as exchange-traded futures contracts or occur without exchange oversight, known as over-the-counter trading.
Options contracts
Options contracts allow traders to invest in top commodities. In these agreements, traders have the right, but not the obligation, to buy or sell a commodity derivative at a fixed price. Commodity investment through options contracts enables individuals to profit from market fluctuations, as no obligation to buy or sell products is imposed on either party, depending on the type of options contract.
Types of Tradersin a Commodity Market:
Speculators:
Speculators constantly examine the costs of commodities in addition to forecasting the expected price changes. For instance, if a speculator predicts that the price of gold is to increase, they purchase the commodity futures contract. If the cost of gold subsequently grows, the trader will sell the contract for a higher price than the buying price.
If the speculator anticipates that the rate of gold will decrease, they sell their futures contract. Once the prices lower, speculators buy the contract again for a lower price than what they sold it for. This is how speculators make profits in both cases of market change.
Hedgers:
Hedgers hedge their risk’ of commodities typically by trading in a commodity futures market. For instance, if the prices of wheat fall during the harvest period, the farmer will face a loss. The farmer can hedge this risk by entering a futures contract. In this case, when the price of his produce falls in his local market, the farmer can offset this loss by making profits through the futures market.
The opposite situation is when the cost of wheat increases during the harvest period. At this time, the farmer would encounter losses in the futures market. However, these losses can be compensated for by selling his produce for a higher cost in his local market.
Factors Determining Commodity Prices
- Market Demand and Supply: Market demand and supply for traded goods influence commodity prices. Increased demand can lead to short-term price rises, often due to a pessimistic outlook in the stock market, pushing investors towards safer investment options.
- Global Scenario: Global events can affect domestic commodity prices. For example, turmoil in Middle Eastern countries can impact crude oil prices, affecting both exports and domestic trading.
- External Factors: Any conditions affecting the production of traded goods can impact prices. Higher production costs can lead to higher selling prices and affect the equilibrium rate.
- Speculative Demand: Speculative investors can influence commodity prices. They aim to profit from price fluctuations by making predictions and closing contracts before expiration. They can choose either short or long positions based on their market assumptions.
Relationship Between Stock Market and Commodity Market
When the economy faces inflation, commodity prices surge whereas stock and bond values decline. For instance, during inflation, rising commodity prices on exchanges compel governments to elevate domestic lending rates.
Consequently, investors shy away from stocks due to increased borrowing costs, causing capital sector prices to plummet. Simultaneously, higher lending rates reduce the attractiveness of fixed coupon bonds, leading to decreased demand and falling bond prices.
Contrastingly, investing in commodities like precious metals becomes lucrative, offering investors substantial returns amid such economic shifts. This inverse relationship between commodity markets and stocks/bonds exemplifies how inflation triggers price movements, impacting various investment avenues.
Benefits of Commodity Market
There are several benefits of commodity market to market participants:
- Contributes to portfolio diversification: The commodity market provides an avenue for diversifying investment portfolios. By including commodities in their investment mix, individuals and institutions can reduce their exposure to risks associated with traditional asset classes like stocks and bonds.
- Mitigates risk: Commodity trading allows market participants to hedge against price volatility and manage risk effectively. Hedging involves taking offsetting positions in the futures market to protect against adverse price movements in the physical market. This helps participants, such as farmers, producers, and traders, to safeguard their interests and stabilize their revenues.
- Boosts investment in the agricultural sector: The commodity market plays a vital role in promoting investment in the agricultural sector. By providing a platform for price discovery and trading, it incentivizes farmers to produce more efficiently and enhances their income prospects. Increased investment in agriculture leads to improved infrastructure, technology adoption, and overall development of the sector.
- Facilitates price predictability: The commodity market enables market participants to anticipate future price movements. Through the trading of commodity futures contracts, participants can gain insights into market sentiment and expectations. This price predictability helps various stakeholders, including farmers and processors, in making informed decisions related to production, procurement, and pricing.
- Enhances aggregation and financing in the agricultural sector: The commodity market facilitates the aggregation of commodities from various sources and enhances their marketability. Farmers and producers can sell their produce directly to buyers in the market, eliminating intermediaries and obtaining better prices. Moreover, commodity trading platforms often provide financing options, allowing farmers and traders to access credit based on their commodity holdings.
Limitations of Commodity Market
- Risk of Uncontrolled Leverage: Trading commodities online often involves greater leverage compared to stocks. However, this increased leverage can tempt traders into making excessive trades. If the market doesn’t align with your predictions, you might end up losing money instead of making profits.
- Dealing with Extreme Volatility: Commodities tend to be more volatile than stocks and bonds. These include crude oil and gold, exhibiting even higher volatility. These significant price fluctuations can be distracting and disrupt your trading strategies.
- Vulnerability to Economic and Geopolitical Factors: Commodity prices are influenced by various economic and geopolitical factors. For instance, an increase in crude oil production can lead to a drop in oil prices and vice versa.
Key Things to Note About Commodity Trading in India
- The prices of commodities are affected by several reasons. Similar to investing in stocks, it is important to prepare in advance by understanding these factors and learning strategies you can employ before you start trading in commodities.
- While you get higher leverage with commodity trading, the risk associated with trading in commodities is also higher as market fluctuations are common.
- Regularly monitoring the market is necessary. If you are a trading beginner, consider taking the help of a commodity market expert who can inculcate you into the process and keep tabs on market fluctuations.
Conclusion
Commodity trading in India is a great way to beat inflation as the costs of commodities grow in areas where inflation grows. However, commodity futures contracts are highly leveraged, making them risk-prone. Regularly monitoring the commodity market is essential, no matter which trading strategy one chooses. Apart from commodity markets, you can also invest in the secondary market. Start your investment journey with Angel One today. Open your demat account in a few clicks!
FAQs
Commodities markets consist of the buying and selling of raw materials like precious metals, crude oil, natural gas, energy, and spices, among others. It comprises both hard and soft commodities that are traded on the stock exchange.
Commodities that are traded are typically sorted into four broad market categories.
- Bullion: Gold, Silver
- Metals: Aluminum, Brass, Copper, Lead, Nickel, Zinc.
- Energy: Crude oil, Natural Gas.
- Agricultural commodities: Black pepper, Cardamom, Castor seed, Cotton, Crude palm oil, Mentha oil, Palmolein, Rubber.
- Live Stock: Live Cattle, Pork, and Feeder Cattle.
A few traditional examples of commodities include grains, gold, rubber, oil, and natural gas. With changing times, there have been new types of commodities which include financial products such as foreign currencies and indexes being exchanged in the marketplace.
The top commodities that are traded a lot in no particular order are: Crude oil, Gold, Silver, Coffee, Natural gas, Wheat, Cotton, Corn and Sugar.
