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 higher returns. However, it also carries 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 thoroughly every aspect of the commodity market to make profits reliably.
What Is a Commodity?
SEBI (Securities Exchange Board of India) has described commodities as tangible goods that can be exchanged with other goods of the same type. The Securities Contracts (Regulation) Act, 1956 (SCRA) stated that 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 items. Some examples of commodities include grains, pulses, gold, aluminium, copper and natural gas.
What Are Commodity Markets?
Commodity markets are places where traders can buy/sell commodities. Trading can occur with both physical commodities as well as financial instruments like futures and options. In India, some of the common categories of commodities are Agricultural (chana, soya bean, jeera, rice, rubber), Metals (industrial metals like aluminium, copper and lead, and precious metals like gold and silver) and Energy (e.g. natural gas, crude oil, coal)
Physical goods and financial contracts on the commodity markets are traded in standardised forms 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 exchange of physical commodities. Traders meet face-to-face to buy and sell commodities, usually agricultural products, precious metals and textiles. Trades are settled instantly on these markets.
- Derivatives Markets
A commodity derivative market is where the trade of commodities occurs through derivatives like futures and options. These financial instruments use spot markets to determine the prices of commodities for trading. The derivatives markets are reliable sources of important information and indicate market movements.
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, such as commodities, financial assets, equities or currencies. Futures and options are the most common types of derivative contracts.
In simple words, 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 predetermined price. In simpler words, the buyer and seller enter into an obligation to buy and sell on a particular date.
Commodity futures contracts are standardised with respect to their size, grade and time and quantity. As a result, every futures contract traded on commodity exchanges shares the same specifications.
- Options Contract
Commodities options contracts provide holders (buyer/owner of the option) with the right but not an obligation to buy and sell an underlying commodity. The buyer has to pay an options premium to own this right. But, an important feature that you need to note is that 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 categorised into agricultural and non-agricultural:
- 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. It may be possible that when the stock market takes a downturn, commodities will generate superior returns.
- 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 commodities exchanges||Party-to-party contract because the buyer and seller may know each other|
|Guarantee of the Trades||The Clearing Corporation provides guarantees of the performance of the contract||Trades take place on mutual 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. 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 centres|
|Participants||Institutional and retail||Farmers, manufacturers, traders, brokers, FPO, 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 receipts/warehouses are there 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|
Commodity trading is subject to market volatility and price fluctuations, but can also provide an effective hedge against inflation. Moreover, it lets you diversify your portfolios and helps to lower risk levels. But, what 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?
SEBI regulates the commodity derivatives market in India. Regulations ensure transparency, fairness in trading and proper management of commodity exchanges. Moreover, commodities can act as an effective tool for portfolio diversification and can act as a hedge against inflation. All of these features have made commodity trading to be relatively safe.
How are the prices of futures determined?
Futures prices depend on the interaction of the bids and offers all over the country that primarily takes place on the commodity exchanges. The offer and bid prices depend on the expected prices on the expiry day of the futures.
How does the futures market benefit farmers?
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 formulate crucial decisions about the cultivation and cropping patterns.