Top Commodity Trading Strategies in India
Commodity trading is gradually emerging as a viable alternative to traditional investment options such as bank FDs, real estate, etc. Apart from contributing to portfolio diversification, it also acts as a hedge against inflation. It is important to know the trading strategies for commodity derivatives to earn optimum returns.
Which Commodities Can Be Traded?
First, let us look at the commodities that can be traded. They are broadly categorised into agricultural and non-agricultural commodities:
- Agricultural Commodities
Here are some of the agricultural commodities that are traded in the commodity derivatives market:
- Pulses and grains- Wheat, cotton, maize, guar seeds, chana
- Edible oil- Mustard oil, palm oil, soy oil
- Spices- Coriander, turmeric, jeera
- Non-agricultural Commodities
Given below are some of the non-agricultural commodities traded in India:
- Energy- Crude oil, natural gas
- Precious metals- Gold, silver
- Base metals- Aluminium, copper, nickel, zinc, tin
How Are Commodities Traded in India?
The commodity market in India comprises many regional exchanges located in different states. These are spot markets, where traders buy and sell agricultural commodities with immediate delivery and cash payments.
The alternative way to trade commodities is through derivatives such as futures and options. These are Standardised financial contracts to buy/sell commodities at pre-decided prices and dates. Traders can speculate on the future prices of commodities using these financial instruments on commodity exchanges like MCX (Multi Commodity Exchange) and NCDEX (National Commodity and Derivatives Exchange).
Primarily there are two types of trading strategies, directional and non-directional. In directional trading strategies, traders buy and sell regularly depending on their predictions and market movements.
Non-directional trading strategies involve buying and selling commodity derivatives simultaneously, irrespective of market movements and have low risks due to locked positions. We will further explore the trading strategies in the next section.
Also Read: Trade in the Indian Commodity Markets
Best Commodity Trading Strategies in India
Discussed below are some successful commodity trading strategies used by traders:
Traders implement this strategy to benefit from uncertainty in the movements of prices in the market. They adopt a long and short position at the same time for a commodity or between two related but different commodities.
- Intra-commodity Spread
A trader/investor adopts a long and short position in two futures contracts of a single commodity but with different maturities to implement the intra-commodity spread strategy. For example, a trader can buy March futures for wheat and sell August futures to take advantage of the price volatility.
This strategy is further classified into bull spreads and bear spreads. When a trader purchases a far-month contract and sells off the current month’s contract, it is known as a bull spread, and its reverse is a bear spread.
A bull spread strategy is implemented when a contract of the current month is overvalued and that of the far away month is undervalued. In contrast, traders use a bear spread strategy when the current month’s contract is majorly undervalued and the far away month’s contract is overvalued.
- Inter-commodity Spread
Traders implement this strategy by adopting long and short positions with respect to futures in closely related but different commodities. These commodities can have the same or different trading contracts.
Suppose a trader is bullish on gold and bearish on silver. He/she can implement an inter-commodity spread by buying gold futures and selling silver futures.
Options trading Strategies
Discussed below are the popular options trading strategies that you can create irrespective of bullish, bearish or neutral market movements:
- Put Buy and Put Sell
Put options give holders the right (but not an obligation) to sell the options off on their expiry dates. A trader can buy/sell put options at different strike prices if he/she expects that price of the underlying commodity will fall.
- Call Buy and Call Sell
If a trader anticipates that an underlying commodity price will rise, he can buy/sell call options at various strike prices. When the trader buys a call option, he/she needs to pay a premium, and when he/she sells off a call option, a margin amount has to be paid.
Covered Short Put
Here, a trader sells a put option and gets the premium and simultaneously holds a long position with respect to the underlying commodity. A covered short put position is a good hedging strategy that helps to increase investment returns while minimising risks.
Covered Short Call
A covered short call position is a combination of a long underlying position and a short call option. A covered call option increases returns and hedges a long underlying position in a stagnating financial market.
Strangles and Straddles
Buying calls and puts simultaneously to benefit from the change in market volatility is a common options strategy. When traders expect volatility, they adopt a long position. But, when traders expect that volatility will be normal and remain within range, they adopt a short position.
A trader follows the long straddle strategy when he/she pays a premium to purchase a call and put options with the same expiry date and strike price.
However, the trader follows a long strangle strategy by purchasing a call and a put option with different strike prices but the same expiry date.
Also Read: Role of Commodity Markets in India
Trading Strategies Using Commodity Indices
Beginners who wish to take exposure to commodities can do so using commodity indices. These are cash-settled contracts, usually small in size compared to futures contracts. Commodity indices provide an overview of the price movements of underlying commodities. Moreover, traders can design multiple trading strategies using futures contracts and commodity indices.
There are three sectoral indices for commodity trading on MCX (Multi Commodity Exchange of India Limited), namely MELTDEX, BULLDEX and ENRGDEX. People can create trading strategies by combining MELTDEX and futures contracts of metals.
Tips for Successful Commodity Trading
Here are some tips for successful commodity trading:
- Exercise Caution with Respect to Leverage
An important feature of commodity trading is high leverage low margin as compared to equity derivatives. Often, traders get enticed by the high leverage and enter commodity markets to earn high returns with a low investment amount and incur losses.
Evaluating the pros and cons of such high leverage before getting into commodity trading is necessary. This is because, though leverage can improve your profits, it can also lead to major losses, if the market moves in the opposite direction.
- Understand Volatility Well
It is important to understand well the overall trend and price movements of the commodity you wish to trade in. You need to choose a lot size while trading a commodity, and often, beginners let the margin availability determine this. On the other hand, experienced traders know the importance of analysing a commodity’s volatility before choosing a lot size.
What is important is to study the volatility in a way so as to benefit from it. A crucial tip for beginners is to start trading in more stable commodities such as gold and crude oil before moving on to more volatile commodities like agricultural commodities and copper.
- Evaluate the Market Cycle
You should observe and understand a commodity’s market cycle to understand the ideal time to make trades. Market cycles of commodities usually depend on demand, supply, macroeconomic conditions and geopolitical factors. For example, demand for gold increases during geopolitical tensions.
- Limit Your Focus
To achieve higher returns consistently for a long tenure, traders need to focus on select commodities. It requires patience because commodity trading requires comprehensive research. So trading in highly diversified types of commodities (say, oil and silver) is not recommended.
- Engage in Scalping-strategy
Scalping is a strategy where a trader remains in the commodity derivatives market for a short time and earns profits mainly from small price movements. When a trader follows this strategy, he makes small gains through small price changes and exits the market before his/her losses offset gains.
As the trader remains in the market for a very short period, there is a low risk of adverse events. If you implement it wisely, scalping can be an effective strategy for commodity trading.
Also Read: What are International Commodity Markets
To sum up, you can engage in directional trading of commodities which involves buying and selling commodity derivatives contracts based on market movements and analysis. You can also engage in non-directional trading strategies using indices, options and intra and inter-commodity spreads, which are low-risk trading strategies for commodity derivatives.
Frequently Asked Questions
Who are the main participants of the commodity market?
Hedgers, financial investors and arbitrageurs are the main participants in a commodity derivatives market. Hedgers include traders, wholesalers, FPCs (Farmer Producer Companies), exporters, processors and a commodity’s value chain participants.
What is the role of a stock exchange in commodity trading?
A stock exchange works under the regulatory framework of SEBI and facilitates trading in commodity derivatives. Standardised derivative contracts are available on these trading platforms, and the stock exchange adds the specifications after consultations with various stakeholders.
What is the Daily Price Limit (DPL)?
In the commodity derivatives market, DPL plays the crucial role of defining the maximum range up to which the price of a commodity futures contract can move in a trading session. Its objective is to protect traders from extreme price movements. Contract specifications mention the DPL, and it differs from one commodity to another.
What is the Final Settlement Price (FSP)?
The settlement price of all open positions upon expiry is the FSP. It is determined after the expiry of a contract by the Clearing Corporation. Every open position on the contract’s expiry day would lead to compulsory delivery.
What is meant by Mark-to-Market?
When a trading day ends, the closing prices determine the Mark-to-Market. It has to be paid by the buyer if the price falls. But, in case the price rises, the seller has to pay it.