Commodity Trading: Meaning, Types & Benefits of 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, there are many factors that 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 trading and more.

What Are Commodities?

Commodities are raw materials used in everything from food to furniture to gasoline. Agriculture products like wheat, cattle, oil, and natural gas, as well as metals like gold, silver, and aluminum, make up commodities. In addition, there are "soft" commodities, like sugar, cotton, cocoa, and coffee, that can't be stored for a long time.

The commodity market has evolved a lot since the days when farmers drove bushels of corn and wheat to the local market. A need for standardised contracts for agricultural products led to commodity futures exchanges in the 1800s. Today, you can trade futures and options contracts on exchanges around the world on a wide range of agricultural, metal, energy, and soft commodities. By using these contracts, producers can offload their price risk to end users and other financial market participants.

Also, since the 90s, commodities have evolved into an asset class with the creation of commodity futures indexes and investment vehicles that benchmark against them. There are a lot of ways to invest in the commodities futures markets, from mutual funds to exchange-traded funds or notes, covering a wide range of commodities, from sector-based exposure to broad commodity exposures.

What Is Commodity Trading?

Commodity trading is buying and selling commodities. We use commodities like grains, cotton, fuel, sugar, gold, copper, zinc, and cotton every day. Additionally, commodities are raw materials that are used to make finished products. Hence, commodities are tangible goods that can be bought and traded.

Furthermore, demand and supply determine commodity prices. Commodities' demand is directly proportional to their price, and their supply is inversely proportional. A commodity's price is also affected by government policies, geopolitical tensions, the global economy, factors of production, etc.

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.

Types Of Commodity Trading

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

Metal

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

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.

Agricultural goods

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

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 (Multi Commodity Exchange Of India)

Commodities traded on the National Commodity and Derivatives Exchange of India

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.

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:

The Methods Of Commodity Trading

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

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.

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. 

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. 

Benefits Of Commodity Trading

Commodities trading has multiple benefits, including

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.

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.

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.

High Leverage Facility

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

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.

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 percent 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.

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.

Inflation-Proof But Not Sure

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.

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.

Asset concentration

In spite of the fact that commodities are primarily used to diversify portfolios, commodity investment tools usually focus on one or two industries, meaning a larger concentration of assets.

Conclusion

In commodity trading, raw materials and tangible goods are bought and sold. Also, there are a number of factors that influence commodity prices, including government policy, geopolitical tensions, and the global economy. Additionally, you can trade commodities on commodity exchanges such as the National Multi Commodity Exchange, Multi Commodity Exchange of India, National Commodity and Derivatives Exchange Ltd, Indian Commodity Exchange, and Universal Commodity Exchange.

Furthermore, there are three types of commodity contracts in India: spot contracts, futures contracts, and options contracts. You can trade commodities directly through stocks, ETFs, and mutual funds. Moreover, this trading has lots of benefits, like diversification, hedging, and lower margins. Additionally, you need a Demat account to trade commodities. Your broker can start a commodity trading account once you provide the necessary documents. For the hassle-free opening of a trading account, you can explore the BlinkX app. This app is easy to navigate and has a user-friendly interface, so creating an account is a breeze.