Understand the Crucial Aspects of the Commodity Market
Investors are gradually becoming aware of the benefits of commodity trading and choosing to opt for it. Apart from an effective diversification tool, commodities also have the potential to generate relatively higher returns.They however carry considerable risks due to the speculative nature of the commodity market, which can lead to wide price fluctuations.
That is why it is essential to understand every aspect of the commodity market thoroughly to make profits reliably.
What Is a Commodity?
Securities Exchange Board of India (SEBI) has described commodities as tangible goods that can be exchanged with other goods of comparable nature and value. The Securities Contracts (Regulation) Act, 1956 (SCRA) states that these goods include any movable property other than actionable claims, securities, and money.
It should be noted that commodities are mainly used as raw materials to produce finished goods. Some examples of commodities include grains, pulses, gold, aluminium, copper, and natural gas.
What is Commodity Market?
Commodity market is a place where traders can buy/sell commodities. Trading can occur with both physical commodities as well as financial instruments like futures and options that have physical commodities as the underlying. In India, the forward market allows market participants to trade around 120 commodities.
Physical goods and financial contracts on the commodity markets are traded in standardised forms, quantity and terms.. Traders usually take part in commodity trading on regulated commodity exchanges such as the Multi Commodity Exchange of India (MCX), National Commodity and Derivative Exchange (NCDEX), and Indian Commodity Exchange (ICEX).
Types of Commodity Markets
There are two main types of commodity markets in India. These are described as follows:
- Spot Markets
Spot markets or physical markets involve the actual exchange of physical commodities (physical settlement). Traders meet face-to-face to buy and sell commodities, usually agricultural products, precious metals, and textiles. Trades are settled instantly on these markets.
- Derivative Markets
A commodity derivative market is where the trades of commodities occur through derivatives like futures and options. Derivativesuse spot markets in the determination of the contract value..
What Are Commodity Derivatives?
Let us first understand what a derivative is. It is a financial instrument whose value is determined by the value of the underlying asset. Underlying assets take the form of commodities, financial assets, equities, currencies,etc. Futures and options are the most common types of derivative contracts.
A commodity derivatives contract has a commodity as its underlying instrument. Derivatives like futures and options have fixed prices and expiry dates for their execution.
Types of Commodity Derivatives
Detailed below are the types of commodity derivatives traded in India:
- Futures Contract
It’s a financial agreement between a buyer and seller to purchase or sell a particular amount of an underlying commodity at a specified time in the future for a fixed price. In simpler words, the buyer and seller enter into an obligation to buy and sell respectively on a particular date.
Commodity futures contracts are standardised with respect to their size, grade, time, and quantity. As a result, every futures contract traded on commodity exchanges shares the same specifications.
- Options Contract
Commodities options contract provides holders (buyer/owner of the option) with the right but not an obligation to buy(call) or sell(put) an underlying commodity. The buyer has to pay the premium of an option to own this right. if options buyers exercise their rights, the seller is obliged to honour the contract.
Types of Goods Traded in the Commodity Markets
Commodities that are traded in the commodity markets can be broadly categorized into agricultural and non-agricultural commodities:
- Agricultural Commodities
Perishable agricultural commodities such as cotton, seeds, maize, wheat, rice, soybeans, etc., fall under this category. In addition, processed agricultural commodities like palm oil, guar, and gum also fall under this category.
- Non-agricultural Commodities
Natural resources that are either mined or processed fall under this category. Given below are some examples:
- Bullion and gems– Gold, silver, other precious metals, and gems like diamonds fall under this category.
- Metal commodities– This category includes many processed and mined non-precious metal commodities. Examples include copper, iron, brass, aluminium, zinc, and tin.
- Energy commodities– This category has commodities that are energy sources and are traded in unprocessed or refined forms or as by-products of processing. Examples include crude oil and natural gas.
Benefits of Commodity Derivatives Market
Detailed below are the various benefits of the commodity market:
- It acts as a nationwide platform for price discovery and helps physical market participants hedge against price risk. It also helps investors diversify their portfolios as commodities may share an inversely proportional relationship with the stock market. So, when the stock market takes a downturn, commodities will protect the downside.
- Compared to the stock market, commodity derivatives require a lower margin. It helps brokers to trade on borrowed funds which helps speculators and hedgers earn a larger share of profits from every transaction.
- The success of market participants in futures trading facilitates the development of important infrastructure like warehousing. It acts as a catalyst for pledge financing via banks and warehousing.
Differences between Commodity Derivatives Markets and Spot Markets
The following table represents the differences between the commodity derivatives market and the spot market:
|Features||Derivatives Market||Spot Market|
|Regulator||SEBI (Securities Exchange Board of India)||Respective state governments|
|Prerequisites||Initial margin before trading||No collateral|
|Nature of Contracts||Standardised||Customised|
|Nature of Trades||Trade takes place between two parties anonymously on commodity exchanges||Party-to-party contract|
|Guarantee of the Trades||The Clearing Corporation provides a guarantee of the fulfilment of the contract||Trades take place on mutual trust and understanding|
|Type of Settlement||Mark-to-Market settlement in cash takes place at the end of the day. Final settlement is via cash/physical mode and takes place upon contract expiry||Physical settlement, which takes place either instantaneously or within 11 days of the deal|
Comparison between Commodity & Equity Derivatives Contracts
Equity and commodities derivatives have equities and commodities as their underlying assets respectively. Though the basic idea of both these derivatives remains the same, there are unique differences.
Given below is the comparison chart between commodity and equity derivatives:
|Parameters||Equity Derivatives||Commodity Derivatives|
|Underlying asset||Financial asset||Physical asset|
|Asset types||Equity shares||Agricultural and non-agricultural commodities|
|Underlying market||Electronic and organised Stock Exchanges (national level) with transparent and continuous price availability||Spread all over the country, with significant trading taking place in important trading and production centers|
|Participants||Institutions and retail||Farmers, manufacturers, traders, brokers, etc.|
|Underlying supply||Available in the public domain and quite certain||Estimated and uncertain|
|Weather||Indirect effect||Direct effect on all commodities|
|Settlement||Demat settlement||Storage infrastructures such as warehouses/vaults are required for physical commodities. Electronic vault/warehouses receipts are provided for commodities in accredited storage locations|
|Period of life of the underlying asset||Standardised and perpetual||Standardised according to the Stock Exchange contract specification and has an expiry date|
Commodities are subject to market volatility and price fluctuations, but they have proven to act as an effective hedge against inflation. they let you diversify your portfolios and help to lower risk levels. All you need to do is understand the different aspects of a commodity market and assess your risk profile before beginning to trade.
Frequently Asked Questions
What is the difference between goods and commodities?
A commodity is primarily a raw material necessary for producing a good. Goods are the final products that are obtained after adding value to commodities. An example of a commodity is cotton, while a finished good is textile.
Is commodity trading safe?
Financial experts consider commodities as effective contributors to portfolio diversification as they mitigate overall risks. An important reason is they act as a hedge against inflation. All of these features have made commodity trading (when done in a calculated fashion) to be relatively safe.
How are the prices of futures determined?
The futures prices are determined by the interaction of bids and offers from all over the country, primarily on commodity exchanges and bid prices are determined primarily by the expectations with respect to the futures price.
How does the futures market benefit farmers?
Many farmers don’t take part in the futures market directly. Instead, they study the price signals that a futures market emanates. It helps a farmer in formulating crucial decisions about the investment intensity of cultivation and cropping patterns.