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Commodity Trading

    IndianMoney.com Research Team | Tuesday, July 21,2009, 06:36 PM
 

The terms “commodities” and “futures” are often used to depict commodity trading or futures trading. It is similar to the way “stocks” and “equities” are used when investors talk about the stock market. Commodities are the actual physical goods like gold, crude oil, corn, soybeans, etc. Futures are contracts of commodities that are traded at a commodity exchange like MCX. Apart from numerous regional exchanges, India has three national commodity exchanges namely, Multi Commodity Exchange (MCX), National Commodity and Derivatives Exchange (NCDEX) and National Multi-Commodity Exchange (NMCE). Forward Markets Commission (FMC) is the regulatory body of commodity market.

It is one of a few investment areas where an individual with limited capital can make extraordinary profits in a relatively short period of time. Many people have become very rich by investing in commodity markets. Commodity trading has a bad name as being too risky for the average individual. The fact is that commodity trading is only as risky as you want to make it. Those who treat trading as a get-rich-quick scheme are likely to lose because they have to take big risks. If you act carefully, treat your trading like a business and are willing to settle for a reasonable return, the possibility of success is very high.

The course of trading commodities is also known as futures trading. Unlike other kinds of investments, such as stocks and bonds, when you trade futures, you do not really buy anything or own anything. You are speculating on the future direction of the price in the commodity you are trading. This is like a bet on future price direction. The terms "buy" and "sell" merely indicate the direction you expect future prices will move. If, for example, you were speculating in wheat, you would buy a futures contract if you thought the price would be going up in the future. You would sell a futures contract if you thought the price of wheat would go down. For every trade, there is always a buyer and a seller. Neither person has to own any wheat to participate. But he has to deposit sufficient capital with a brokerage firm to insure that he will be able to pay the losses if his trades lose money.

Players Involved in Commodities Trading

There are three different types of players in the commodity markets such as :

  • Commercials
  • Large Speculators
  • Small Speculators

Commercials


The entities involved in the production, processing or merchandising of a commodity. For example, both the wheat farmer and biscuit manufacturer are commercials. Commercials account for most of the trading in commodity markets.

Large Speculators


A group of investors that pool their money together to reduce risk and increase return. Like mutual funds in the stock market, large speculators have money managers that make investment decisions for the investors as a whole.

Small Speculators


Individual commodity traders who trade on their own accounts or through a commodity broker are called as small speculators. Both small and large speculators are known for their ability to shake up the commodities market.

How to Start Trading Commodities

In order to trade commodities, you must educate yourself on the futures contract requirements for each commodity and of course learn about trading strategies. Commodities have the same principle as any other investment, you need to buy low and sell high. The difference in commodities is that they are highly leveraged and they trade in contract sizes instead of shares. Remember that you can buy and sell positions whenever the markets are open, so rest assured that you don’t have to take delivery of a truckload of soybeans.

Why commodities trading?

Commodity trading offers you flexibility in all the areas such as buying, storing, handling, selling, etc. of commodities. For example; if you want to buy gold because you believe that the price of gold will rise. You could then buy gold bars, store them, wait for them to go up in price, and then sell them at a profit. But, you have to be sure that the gold you buy is pure, you have to find a place to store it, you have to provide the security, transport it to vault and other such hassles. A far better way to invest in gold would be to buy gold futures from the commodities exchange. Here you don’t have to worry about the purity, storage, security, transportation, etc. of the goods purchased.

How do you do Commodity Trading?

When you buy a Commodities Futures contract, you undertake to do three things.

  • Buy the amount of Commodity specified in the contract.
  • Buy it at the price specified in the contract
  • Buy it on the expiry of the contract. This could be after one month, two months, three months and so on. Of course, if you sell the Commodities Futures contract before it expires, you don't have to worry about actually buying the commodity.

For example: Let's say you buy the Gold Future contract at Rs 14,000 per 10 gm. Your guess comes true and the gold prices rally to Rs 15,000 per 10 gm. You can sell the Gold Futures any time before expiry of the contract.

Gold and other commodity futures prices are quoted on the commodity exchanges in exactly the same way in which stock prices or stock futures prices are quoted on a daily basis in the stock markets.

How Commodity Market works

Commodity Market works Just like stock futures. When you buy Futures, you don't have to pay the entire amount, just a fixed percentage of the cost. This is known as the margin. Let's say you are buying a Gold Futures contract. The minimum contract size for a gold future is 100 gms. 100 gms of gold may be worth Rs. 1,50,000. The margin for gold set by MCX is 3.5%. So you only end up paying Rs 5,250.

The low margin means that you can buy futures representing a large amount of gold by paying only a fraction of the price. So you bought the Gold Futures contract when it was Rs. 1,50,000 per 100 gms. The next day, the price of gold rose to Rs 1,60,000 per 100 gms. Rs 10,000 (Rs 1,60,000 - Rs 1,50,000) will be credited to your account. The following day, the price dips to Rs 1,55,000. Rs 5000 will get debited from your account (Rs 1,60,000 - Rs 1,55,000).

What you need to know

Compared to stocks, trading in commodities is much cheaper, because margins are much lower than in stock futures. Brokerage is low for commodity futures. It ranges from 0.05% to 0.12%. Because of this, commodity futures are a speculator's paradise. If you are a hard-core trader who follows the technical charts and do not really care what you trade, and if you are lively and confident, then commodity futures could be another asset class that you would be interested in. The advantages in this line is that there are no balance sheets, no complicated financial statements, all you have to do is follow the supply and demand position of the commodities you trade in very closely.

Go onto the commodities trading exchange - NCDEX and MCX - to see which commodities are offered for trading including their contract size and other criteria. You will have to get hold of a commodities broker but that should not be a problem. There are lots of brokers that offer commodity trading these days. But, it would be wise to avoid commodity trading if you are an inexperienced person; A better move would be to initially trade in stock futures before opting for commodity futures.

IndianMoney.com Research Team

The research team at IndianMoney.com comprises of certified and experienced professionals who share the company's vision to make every Indian financially literate by equipping every Indian with right and unbiased advice. IndianMoney.com research team provides newsletters, articles, videos and FAQs on various financial products and concepts only to help you make wise financial decisions.

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