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What is Commodity Trading

What is Commodity Trading

Commodity trading involves buying and selling commodities, which are tangible goods used in everyday life as well as raw materials used in finished products. Also, many factors can influence commodity prices, including government policies, geopolitical tensions, and the global economy.

However, before investing in commodity trading, it is important to understand the commodity market and the trading platforms available. To help you make informed decisions about commodity trading in India, this article describes in detail what is commodity trading, its types, commodities exchanges, methods of commodity trading and more.

Understanding Commodity Trading in India 

Commodities are raw materials used in various industries, including food, furniture, and gasoline. They include agriculture products, metals, and soft commodities like sugar, cotton, cocoa, and coffee. Commodities have become an asset class since the 90s, with commodity futures indexes and investment vehicles benchmarking against them. Commodity trading involves buying and selling commodities like grains, cotton, fuel, sugar, gold, copper, zinc, and cotton. Prices are determined by demand and supply, with factors like government policies, geopolitical tensions, the global economy, and production also impacting prices.

For example, reduced rains could affect the cotton supply and raise cotton prices in that year. Likewise, the advent of electric vehicles may reduce the demand for fuel and reduce its price.

Moreover, there are different types of commodity trading contracts whose value is derived from the underlying commodity. In India, there are three types of commodity contracts: spot contracts, futures contracts, and options contracts.

  • Spot contracts are instant contracts for the trading and settlement of commodities.
  • In commodity futures trading, future prices are standardized. With a futures contract, the buyer has the right and the obligation to buy the commodity at a predetermined rate in the future, while the seller must sell it at the same rate.
  • A commodity options contract gives the buyer the right to purchase the commodity at a specified price in the future, but not the obligation to do so.

Typically, commodity contracts require delivery at the end, either as a delivery or as a cash settlement. On termination of the contract, delivery refers to the transfer of the physical goods. Whereas, cash settlement involves the settlement of differential prices in expectation. In most cases, cash settlements are preferred over delivery.

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Table of Content

  1. Understanding Commodity Trading in India 
  2. Types of Commodity Trading
  3. Types of Commodities Traded In India on MCX and NCDEX
  4. How Commodity Trading  Works
  5. Benefits of Commodity Trading
  6. Disadvantages Of Commodity Trading 
  7. Commodity Exchanges in India 
  8. The Methods of Commodity Trading

Types of Commodity Trading

More than 100 commodities are traded on 50 major commodity markets worldwide. Traders can trade commodities in four categories:

  1. Metal

    Various metals, such as iron, copper, aluminium, nickel, and gold, as well as precious metals like silver, platinum, and gold, are traded in the market.

  2. Energy goods

    Household and industrial energy goods are traded in bulk. They're natural gas and oil. In addition to uranium, ethanol, coal, and electricity, other energy commodities are traded.

  3. Agricultural goods

    The commodity market trades a lot of agricultural stuff. Things like sugar, cocoa, cotton, spices, grains, oilseeds, pulses, eggs, and feeder cattle.

  4. Environmental goods

    In this group, you'll find renewable energy, carbon emissions, and white certificates.

A few of the most traded commodities around the world are gold, silver, crude oil, Brent oil, natural gas, soybeans, cotton, wheat, corn, and coffee. 

Types of Commodities Traded In India on MCX and NCDEX

Here are the commodities Traded on the Multi Commodity Exchange Of India (MCX) and the National Commodity And Derivatives Exchange (NCDEX):       
 

Category

Commodities on MCX

Commodities on NCDEX

Agricultural Castor Seed, Cardamom, Cotton, Mentha Oil, Rubber, Palmolein, Black Pepper, Castor Seed Castor Oil, Black Pepper, Palmolein, Barley, Wheat, Chana, Moong, Paddy (Basmati), Maize Kharif/South
Oil and Oil Seeds

Soybean, Mustard and Cottonseed Oils, Crude Palm Oil

Refined Soy Oil, Cottonseed Oil Cake

 

Soybean, Mustard and Cottonseed Oils, Crude Palm Oil

Refined Soy Oil, Cottonseed Oil Cake

Bullion Gold, Silver Gold, Silver
Energy Natural Gas, Crude Oil -
Base Metals Brass, Aluminium, Lead, Copper, Zinc, Nickel -
Soft - Sugar
Fibers - Cotton, Guar Seed, Guar Gum
Spices - Pepper, Jeera, Turmeric, Coriander

How Commodity Trading  Works

Imagine you bought gold futures on MCX for Rs. 72,000 per 100 grams. On MCX, gold's margin is 3.5%. That means you'll pay Rs. 2,520. Let's say the price of gold goes up to Rs. 73,000 per 100 grams the next day. You'll get Rs 1,000 credited to the bank account you linked. Let's say it drops to Rs. 72,500 the next day. In that case, your bank account will be debited with Rs. 500.

With commodity trading, you get more leverage, but you're also taking on more risk because stock market fluctuations are common.

Benefits of Commodity Trading

Commodities trading has multiple benefits, including

  1. Diversification

    Increasing commodity prices tend to negatively impact the cost of production and the overall business, so returns in commodities markets are inversely proportional to equity and debt markets. Therefore, investing in the commodity markets may reduce the risks associated with capital markets.

  2. Hedge Against Event Risk

    Gold prices rise faster than inflation. An increase in real value can be good for investors. As a result, commodity trade hedges inflation. Alternatively, enterprises can fix raw materials' prices by buying or selling commodity contracts. For example, cloth manufacturers can freeze cotton prices and avoid the risk of rising prices. This improves cash flow management and financial planning.

  3. Low Margin

    Compared to stocks and bonds, commodity trading has a lower margin. As a trader, you have access to borrowed capital and can increase your exposure to commodities. Moreover, when you settle in cash, you get a better return since they settle the differential price.

  4. High Leverage Facility

    Investing in commodities can boost traders' profits. By paying a 5 to 10% margin, traders can take a significant position in the market. In this way, even a small price increase can increase profit potential. Even though margins vary from commodity to commodity, they're still lower than equity margins.

  5. Transparency

    Commodity markets are growing and highly regulated. With the modern electronic trading suite, the market is more transparent and efficient, and manipulation is reduced. It enables fair price discovery through broad participation.

Disadvantages Of Commodity Trading 

There are a few disadvantages to commodity trading that you should know before investing.

  1. Leverage

    When you're inexperienced with margin trading, it can be a double-edged sword. The advantage of leverage is that traders can bid big on the market. A 5% margin lets you buy commodity futures worth Rs 100,000 for just Rs 5000. This means that traders can lose a lot even if the price drops a little.

  2. High Volatility

    The high price volatility of commodities gives traders higher returns. When demand and supply are inelastic, price is driven by demand and supply. Commodity futures can change significantly in value when supply and demand remain unchanged despite price changes.

  3. Inflation-Proof But Uncertain

    Even though commodities and securities have a negative correlation, they're not good diversifiers. A rise in inflation, a rise in unemployment, and a fall in demand for raw materials affect companies' production.

  4. Returns Are Low For Buy-And-Hold Investors

    Bulk investment is needed to make money in commodity trading. Historically, even the highest-rated government bonds have generated more returns than commodity trading. This is mainly due to the cyclical nature of the products, which makes buy-and-hold investments less valuable.

  5. Asset concentration

    Even though commodities are primarily used to diversify portfolios, commodity investment tools usually focus on one or two industries, meaning a larger concentration of assets.

Commodity Exchanges in India 

A commodity exchange is a regulated market where you can trade commodities. These are some of the major commodity exchanges in India:

Commodity Exchange Year of EstablishmentCommodities Traded
National Multi Commodity Exchange

2002

Mustard, rubber, jute, gold, aluminium, copper, etc.
Multi Commodity Exchange of India

2003

Metal, bullion, energy, Pulses, Cereals, petrochemicals, etc
National Commodity and Derivatives Exchange Ltd

2003

Fibres, seeds, oil, steel, copper, etc
Indian Commodity Exchange

2009

Gold, silver, lead, copper, natural gas, soybean, etc
Universal Commodity Exchange

2013

Chana, mustard, soybean, turmeric, etc

The Methods of Commodity Trading

Several methods are available for trading commodities. Among them are:

  1. Investing directly 

    Commodities are most commonly invested in this way. You can directly buy gold, silver coins and jewellery. However, direct investments in these items have high transaction costs. Also, there are issues related to purity and storage.

  2. Buy stocks 

    Commodities can also be traded by purchasing stock. For example, if you are interested in trading energy, you can buy stocks from an energy company. The price of energy will closely affect the stock price. Also, it is possible to make profits by investing in commodities through direct stocks, even if the commodity is not doing well. Like, even if energy prices go down, you can still make profits if you own shares of an established energy company.

  3. Commodity ETFs and Mutual Funds

    Commodity-based ETFs and mutual funds are widely available. You can invest in gold or silver ETFs if you want exposure to gold or silver. Additionally, ETF units are held electronically in your Demat account, so there are no purity or storage issues. 

Conclusion

Commodity trading involves buying and selling raw materials influenced by government policies and global economic conditions, with various commodity exchanges available. India has three types of commodity contracts: spot, futures, and options. Trading can be done directly or through stocks, ETFs, and mutual funds, offering benefits like diversification and hedging. A Demat account is required, and the BlinkX app provides a hassle-free option for opening a trading account with its user-friendly interface, making it a convenient choice for those looking to engage in commodity trading through an online trading app.

FAQs on Commodity Trading

Gold, natural gas, copper, aluminium and crude oil are the best commodity for trading in India.

Just like equity or shares, you can buy and sell tradable commodities. A commodity is bought with the expectation that it will appreciate in price. As soon as the price hits your target, you sell it. On the other hand, sellers sell commodities when they think the price won't rise.

After you've done your research and decided on what investments are right for you, you can start trading commodities by opening a brokerage account and buying shares in a commodity-specific company of your choice or a commodity ETF.

The best commodities for beginners are copper, oil, and gold.

Yes, you can hold commodities for the long term.

The three types of commodities are agricultural (e.g., wheat), energy (e.g., crude oil), and metals (e.g., gold).

Commodity trading's ease depends on knowledge and market understanding; beginners may find it challenging, but with education and experience, it becomes more manageable.