Pros and Cons of Commodity Trading
Commodity trading is a common term used in the investment parlance. Apart from equities, investors can also trade commodities in the market. This way, investors can easily diversify their investment portfolio and increase their profits. Moreover, commodities can generate great returns in the long term when people invest with prudence.
However, there is a high degree of volatility in these markets that make it difficult to trade. These are the pros and cons of commodity trading that you should learn about.
The following sections will explain this in more detail.
What Is Commodity Trading?
The term commodity refers to raw materials like food (rice, grains), energy (crude oil, petrol), metal (gold, silver) and other similar things that are frequently traded in the market. Commodity trading happens when people exchange such commodities in the commodities exchange. If you wish to trade such commodities in the exchange, you must have a demat account.
In India, the following exchanges oversee the trading in the commodities market:
- NCDEX (National Commodity and Derivatives Exchange Limited)
- MCX (Multi Commodity Exchange of India Limited)
- Bombay Stock Exchange (BSE)
- National Stock Exchange (NSE)
- Indian Commodity Exchange (ICEX)
Below we have discussed both advantages and disadvantages of commodities trading in India.
What Are the Advantages of Commodity Trading?
The various advantages of commodity trading are as follows:
- Protects against inflation
The rise in the prices of goods and services over time is known as inflation. With increase in the demand for goods and services in the market, manufacturers need to increase the use of raw materials, which increases their prices.
. Invest in commodities will help you maintain parity with increasing prices and provide a good hedge against inflation.
- Offers High-leverage Facilities
Many commodity derivatives, like futures and options, offer investors a high percentage of leverage. Leverage refers to borrowing funds to finance the purchase of assets. To obtain funds, traders need to deposit a minimum amount called margin.
Investors can easily increase their trading positions in commodities using borrowed funds, and they need to pay only a 5% or 10% upfront margin of the contract value.
If there is any significant movement in the commodities market’s price, the investors can make exponential gains.
- Hedge against Geopolitical Tensions
Geopolitical events in a country refer to riots, war, political unrest, etc. Such tensions can lead to the disruption of the supply chain in a country’s economy. As a result, the country will have a scarcity of resources. Another reason for the scarcity of resources during such situations is the difficulty in transporting raw materials to manufacturers.
However, trading the commodities market will help reduce the losses in an investor’s portfolio.
Commodities tend to have a negative or low correlation to traditional asset classes such as stocks and bonds. If the prices of commodities increase, the cost of production increases. As a result, the manufacturer’s profit will usually decrease because most of its earnings will go into purchasing raw materials.
The profits left for shareholders to divide among themselves will also decrease. As a result, inflation will lead to the prices of a company’s shares going down. In contrast, commodities tend to perform exceptionally well when the inflation rate keeps increasing.
If you incur losses because of inflation, you can make up for your losses in the commodities market. It is a good idea to diversify your portfolio into commodities, especially in an inflationary market.
We can explain the benefit of keeping commodity trading in your investment portfolio for diversification with an example. Let us say that today the prices of fuels like petrol and diesel are increasing. Then, the price of maintaining a car or bike will also increase.
This will discourage people from purchasing more such vehicles. As a result, the prices of shares for automobile manufacturing companies will drop, resulting in investors losing a lot of money. However, if the same investors opt for commodity trading in petrol or diesel during this time, they can make up for their losses.
Trading in the commodities exchange is highly transparent because commodity deals are now handled on an electronic platform. This platform is available to all market participants. It is very different from the previous approach, which was quite chaotic in many experts’ opinion.
New electronic trading platforms used for commodity trading facilitate fair price discovery. It allows large-scale participation as buyers and sellers do not meet. This way, this platform eliminates the possibility of price manipulation.
Furthermore, price discovery occurs in commodity trading when a supplier quotes the price, and a customer’s buying offer matches it. Throughout the entire transaction process, the buyer and supplier will remain anonymous to each other. This facilitates simple transactions and eliminates any manipulation.
What Are the Disadvantages of Commodity Trading?
While there are many advantages of commodity trading, it also carries several disadvantages. Given below are a few disadvantages of commodity trading to consider:
- High Volatility
The prices of commodities are highly volatile. They depend mostly on supply and demand but also on external factors like geopolitical events, natural disasters and political situations. Such events can immediately alter the prices of commodities in the market. As a result, it can take a lot of work for investors to analyse the price, and there is no way to eliminate all risks.
According to finance experts, commodities are some of the most volatile asset classes in which one can invest money. They are twice more volatile than stocks and four times more volatile than bonds. The volatile nature of commodity trading makes it a risky investment tool for most investors.
Since commodity trading is a highly volatile investment tool, it attracts investors looking for short-term profits with a very short investment horizon. Consequently, constant mass movement from such speculators creates fluctuations in the prices of commodities.
- Asset Concentration
Commodity funds offer an easy way for investors to diversify their investment portfolios. However, commodity funds themselves are concentrated in one or two industries. So if an investor keeps commodity trading in his/her portfolio, it will become challenging for the individual to diversify his/her portfolio.
- Environment Issues
A lot of the time, the commodities investors trading in the commodities market tend to hurt the environment. This is because, to meet the rising demand and supply, sometimes suppliers and producers take up methods which are unethical and can cause harm to the environment.
There are numerous legislations worldwide made to bring sustainable practices in sectors like farming and livestock. However, many people still continue practices that hugely cause damage to the environment for profits.
For example, if a country’s demand for crude oil rises, its price will also rise in the commodity market. However, to meet this rising demand, suppliers will adopt practices which will cause harm to the environment.
- Over-Leverage Can Be Burdensome
There are two sides to the coin of leverage in commodity trading. First, as we previously covered, leverage enables you to manage a sizable investment by paying a small margin.
Therefore, as a trader in the commodity market, you can easily purchase commodity futures worth ₹1,00,000 with ₹5,000. So as an investor, your initial margin requirement or cash outlay would only be 5%. However, if any minor change occurs in the market, then prices will hugely impact an investor’s losses and gains.
If the prices of any commodities in the market fall by just ₹10, an investor will lose as high as ₹10,000. This will happen when a lot size is 100, and this investor has purchased 1,000 contracts. Since low-margin requirements bring excessive risk, this investor might lose all his or her investments in the commodities market. Therefore, over-leverage can be burdensome for some investors.
Things to Consider before Investing in Commodities
Before you start trading in the commodities market, there are a few things that you should take into consideration, and they are:
- Trading Volume- The volume of commodities hugely impacts the choice of commodities that an investor makes. The volume of any commodity will tell you how many traders are purchasing or selling any commodity on a specific date.
A higher volume of any commodity will increase volatility, but it will also create many opportunities for intraday trading so that traders can make substantial profits. As a result, high-volume commodities have to potential to generate substantial returns for traders.
- Risk Profile Analysis- Analysing risk is one of the essential components that you, as an investor, should consider when choosing a commodity for transactions. Specific risks are involved with trading in the commodities market. Therefore, assessing your risk appetite will help you understand whether you want to trade in the commodities market.
It would be best if you kept in mind that higher-risk transactions have the potential to generate more returns. However, they carry higher risks of losses.
- Choosing Popular Commodities- Many different types of commodities are available in the commodity market. The four main categories are agriculture, energy, base, and precious metals. Among these, the most popular commodities on the market are crude oil, silver, gold, natural gas, zinc, and soybeans. These popular commodities have the potential to generate greater returns.
- Avoiding Unpredictable Commodities- Knowing the market will help you anticipate the movement of a commodity’s futures. A commodity with a brief bull run in the market before it collapses is not a great investment option. However, investors can generate significant returns during its bullish trend, but the risks involved will also be higher. Therefore, it is essential to know and experience transactions in the commodities in the market.
As an investor, you can access an entirely new market through online commodity trading. Many seasoned investors and experts believe that commodity trading is more dependable than equity stocks. However, stock market investors believe equities stocks are more profitable and simpler to grasp than commodities.
As an investor, you need to learn about both the pros and cons of commodity trading. So, you can opt for a better investment based on your financial goals and risk appetite.
Frequently Asked Questions
1. What are some “Do’s” in commodities trading?
Here are some “Do’s” that an investor should keep in mind for commodity trading:
- While trading in the commodities market, choose a registered broker through whom you will make the transactions.
- Thorough research and understanding of the procedure for delivery and settlement are essential.
- Ensure that you receive a periodic statement for your ledger account.
2. What are some “Don’ts” in commodity trading?
Below are some “Don’ts” in commodity trading:
- Do not let the speculations, attractive marketing, claims, or bullish or bearish market sentiments fool you.
- Avoid trading any contract before you learn about any associated risks.
- Refrain from engaging in off-market trades.
3. What is the difference between goods and commodities?
A commodity is raw material manufacturers use to create any final product. This final product is called goods the manufacturer created by adding value to the final product. For example, gold is a commodity, but gold jewellery is good.
4. How can I start commodity trading?
If you wish to trade in the commodity market, you will need to have a trading account. To make a trading account for yourself, you will need to take the assistance of a certified and registered brokerage firm. Now your trading account will help you in trading in the commodities market by acting as an exchange place.