Introduction to Commodity Trading
Till a couple of years back I used to often wonder why do newspapers and economic news channels run news and ticker about common everyday use products like pepper, wheat, soya bean etc. Well gold, silver and oil I understand but why these ordinary things?
Now I am wiser and know that all these products are actively traded and commodity trading is an effective tool for portfolio diversification and beating inflation.
Commodity Trading is an investing strategy wherein goods are traded instead of stocks. Commodities traded are often goods of value, consistent in quality and produced in large volumes by different suppliers.
What is a Commodity?
Any product which exists naturally and serves as an input for the secondary market can be described as a commodity. They can be classified as agricultural products like cotton, wheat, pepper etc or non-agricultural products like crude oil, gold, and copper and so on.
Agricultural products are prone to spoilage and their availability is dependent on weather condition; their market is more volatile. Non-agricultural products etc like oil, copper are useful in industries (for producing derived or secondary products) and are generally preferred by investors.
For a product to be classified as a commodity it should have a commercial value; all commodities are not traded in the commodities market. Commodities are fungible which means they are same irrespective of who produces it and are processed further into other products.
What is Commodities Market?
In the heydays commodities market would be a physical marketplace where trading in commodities would take place. In current times they are virtual platforms provided by commodities exchanges all over the world to facilitate trading in commodities. Pre-independence there was a flourishing market in India for gold, silver, oil etc. Indian Government stopped commodity trading around 1960 and it was re-introduced in 2003.
There are about fifty commodities markets in the world dealing in close to a 100 primary products. In India, there are three national level and 24 regional exchanges that allow trading in almost sixty commodities.
The three national exchanges are the National Commodity and Derivative Exchange, the Multi Commodity Exchange of India Ltd and the National Multi Commodity Exchange of India Ltd. All three exchanges have electronic trading settlement and a national presence. The MCX (Multi Commodity Exchange) located at Mumbai is the sixth largest commodity exchange in the world.
Commodities market can be the spot market or the derivative market. Spot market involves buying or selling of the specific commodity with immediate delivery. This is done by the actual users and the producers.
Commodity Derivatives are agreements to buy or sell an underlying asset up to a certain time in the future at an agreed price known as the exercise price.
The derivative market involves only a contract to buy/sell at a future at an agreed price with no actual delivery taking place. When an investor wants to take a buy or a sell position based on the expected price movement of a commodity in the future he/she can do so by trading in commodity derivatives.
If an investor feels that the price of a commodity are expected to go up he will take a long position (buy a contract); if he feels the price will go down he will take a short position (sell it).
How to Trade in Commodities?
Initially buying and selling of commodities was done by producers or end users to hedge against the risk of price fluctuation; however this is not the case today. Most commodity trading (in the current scenario) takes place between people who have nothing to do with the specific commodity and no actual exchange or delivery of product takes place.
While I may trade in oil and cotton futures I neither drill oil nor grow cotton and no barrels of oils or sacks of cotton will be delivered at my doorstep.
So if one wishes to invest in commodities the person will have to buy/sell a commodity derivative based on the individual choice and market data. To actually trade in futures you will have to open a commodities trading account with a financial intermediary of your choice which allows you to use their virtual platform for buying/selling derivatives.
In India commodity markets are regulated by the Forward Markets Commission. Each financial intermediary is affiliated to one of the national exchanges so actually the trading happens through the exchange.
Why to Invest in Commodities?
Often inflation is a cause of worry for most people. Rising prices of essential daily use commodities causes household budgets to go haywire but this can present an opportunity for investment also. So next time you think investment think of the humble potato before you think of real estate.
Below is chart that gives a comparison between returns on various investment options for the year 2012-13. The first eight slots are occupied by the commodities (futures).
As per a study by Business Today, commodities that are expected to give a good return in 2013 are: Cardamom, wheat, maize, zinc, copper, silver and gold.
In the 70s decade commodities futures outperformed stocks world over; however during the 1980s the exact opposite happened due to the negative correlation that exists between stocks and commodities. (This is as per a study conducted by Yale)
Benefits of Commodity Trading
- Helps in beating inflation
- Is an effective tool for diversification of portfolio
- Hedging of Risk.
- Trading in futures involves the potential of very high profit and an equally high loss.
- Information available for commodities futures is not as reliable and accurate when compared to equity market.
- Commodities are more reactive to weather conditions, global markets especially for crude and gold etc.
The above table gives returns for the last year but every investor knows that returns have to be viewed over a long period to be able to reach a decision. Commodities market is relatively in the nascent stage after the reintroduction so getting accurate and timely information might not be easy. It is better to base your decisions on information rather than speculation.