One of the most important aspect of wealth creation is building a well-diversified portfolio. This means, you should invest in different asset classes, such as equities, debt, real estate, and commodities – to name a few. You can learn about the benefits of multi-asset strategies in our previous blog by clicking here.
To learn how to start investing in the stock markets, click here.
Trading in the commodity market will enable investors to further diversify their portfolio. It has a low correlation with the equity markets, and is relatively easier to understand as prices are impacted by the basic economics of demand and supply. When invested prudently, commodities have the potential to generate good returns in the long run.
In this article, let us take a look at the basics of Commodity Trading. We will cover:
- What is Commodity Trading
- Types of Commodities
- Commodity Exchanges in India
- How to Trade in the Commodity Market
The commodity trading research team at Prabhudas Lilladher guides investors to make wise trading and investment decisions in metals, bullions, crude oil, and agro-based commodities. To know more, click here.
What is Commodity Trading
Commodities are the raw materials or resources that are used for consumption or used to produce refined goods. This includes wheat, rice, metals, and minerals.
Globally, commodities are regarded as the building blocks of an economy. When these commodities and their derivatives are bought and sold, it is known as commodity trading.
Hedgers (such as farmers and manufacturers) and Financial Investors (such as Intraday and Position traders) are among the key players in the commodity trading markets.
The Hedgers have a risk due to physical exposure to the commodity, and are looking to pass on the risk by taking a sell or buy position on Stock Exchange. On the other hand, the Traders don’t have physical exposure to the commodity. But, they take a buy or sell position to make gains from the price movement in the commodity.
It might be noted that several factors affect the prices of commodities – such as demand and supply, seasonality, weather, relevant news, geo-political developments, macro-economic conditions, currency movements, global factors, etc.
So, by trading in commodities, the participants benefit from a transparent, nationalised platform for discovery of prices. It also enables physical market participants to hedge their price risk.
Commodity trading occurs in two types of markets:
Spot Market is where the buyer and seller agree upon the price of the commodity and take physical delivery of the commodity. In India, the state governments regulate this market.
In Commodity Derivatives Market, the trade takes place between two parties on the commodities exchange platforms. As the name suggests, Derivatives is a financial contract that ‘derives’ its value from an underlying asset’s price movement, in this case commodities. The details of this trade are captured in a Commodity Derivative Contract, specifying details such as the lot size, price, and expiry date of the contract.
The delivery can be in the form of cash or physical, on or before expiry of the contract. In India, the Securities and Exchange Board of India (SEBI) regulates the commodity derivatives market.
Types of Commodities
The commodity exchanges are allowed to conduct futures commodity trading for around 120 commodities in India. It can be divided into the following types:
According to SEBI, these are generally perishable agricultural products such as cotton, rubber, maize, soybean, sugar, etc. Processed agricultural commodities like palm oil, soybean oil, etc. are also considered as agricultural commodities.
The other 3 categories are the Non-Agricultural Commodities that are mined or processed such as the crude oil, gold, silver, etc. The SEBI classifies it as follows:-
Bullion and Gems: Consists of precious metals like gold, silver and precious gems like diamond
Energy: Includes commodities that serve as major energy sources and are traded in the unprocessed form, refined forms or by-products of refining / processing. Crude oil and natural gas are examples of commodities in this category.
Metal: Includes various non-precious metals that are either mined or processed from the mined metals. For example, Aluminium, Brass, Copper, Iron, Lead, Nickel, Zinc, etc.
Commodity Exchanges in India
Just like the stock exchanges that are used for trading stocks (equities), there are commodity exchanges which enable you to trade in commodities. In India, there are around 5 prominent commodity exchanges.
- National Commodity and Derivative Exchange (NCDEX)
- Multi Commodity Exchange of India (MCX)
- Indian Commodity Exchange (ICEX)
- National Stock Exchange (NSE)
- Bombay Stock Exchange (BSE)
For a detailed list on all the commodity exchanges in India, and to understand the difference between them, read our detailed blog here
How to Trade in the Commodity Market
For trading in the commodity market, you need to first open a demat account.
Once your account is opened, you need to make an initial deposit in your account. Typically, it is 5-10% of the contract value. After this, you can start placing your trades. You also have to provide a maintenance margin, to cover for any potential losses.