What Is Commodity Trading? Overview and Benefits of Investing
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Commodities are raw materials such as coal, cotton, petroleum, wheat, or gold used to manufacture other goods. As consumers, we can purchase commodities in raw or processed form. These goods hold high relevance in the trading market. Commodities bear the same price regardless of the company or organisation that produces them.
The following section will cover everything you need to know before participating in commodity trading.
What Is Commodity Trading?
The process of buying, selling, and exchanging commodities is commodity trading. Individuals can buy or sell physical commodities on the spot markets or via futures or options.
People can trade in commodities in their country’s commodity exchanges. Trading of physical commodities takes place in barrels or lots. After the maturity date, buyers must take physical delivery of the product and pay in cash.
However, investors can indirectly trade in commodities using derivatives like futures and options or exchange-traded funds (ETF). Alternatively, one can invest in stocks of companies trading in commodities or commodity mutual funds.
Commodity trading works with the prices of the commodities that are involved. This allows individuals to benefit from price fluctuations in the market. Trading in commodities can also help to diversify an individual’s portfolio.
Any individual interested in community trading must have a trading account to participate. Commodity trading in India can happen directly or via commodity future trading or options trading.
Different Ways of Investing in Commodities
You can invest in commodities using these methods:
- Commodity ETFs and Mutual Funds.
These help you invest in commodities like gold or silver. With ETFs, you do not need to worry about safety or to possess them physically. Moreover, you can be assured of the purity of these metals when investing in ETFs and commodity funds.
- Commodities Futures
Another popular commodity trading method is using derivatives like futures. Using commodity futures, individuals can enter a deal with another trader to purchase or sell a specific commodity on a particular date. Individuals are obliged to conduct this exchange on a pre-defined date.
- Purchasing Physical Commodities
Besides ETFs and futures contracts, you can also directly trade in physical commodities and possess them. This can benefit you while trading with commodities like wheat, eggs, coal, or oil. However, this type of investment always carries a looming risk of theft and burglary, especially with precious metals.
Include Commodity Stocks
What Are Some of the Commonly Traded Commodities?
The following are some of India’s most common goods for commodity trading:
This category includes energy sources like natural gas, crude oil, and biogas. Other sources of energy that power industries, including coal, uranium, electricity, and ethanol, also fall under this category.
- Base Metals
This includes metals such as copper, lead, zinc, and aluminium, commonly used for industrial purposes.
- Agricultural Materials
Raw materials like spices, cereals, and clothing that farmers cultivate fall under this category. Include how it is a type of soft commodity
This category comprises precious materials like gold, silver, and platinum.
Among all of them, gold, crude oil, coffee, wheat, and silver are some of the most traded commodities. Moreover, these are traded in high volume across the globe. Before investing, one must know that price movements of these commodities in one part of the world can impact the other half of the earth.
What Are the Types of Commodity Trading Markets in India?
There are two popular types of commodity trading markets in India:
- Spot Markets.
These are physical marketplaces where the exchange and trading of goods occur physically. Here, the delivery of goods and payments are done instantly. Spot markets are also known as cash markets and physical markets.
Here, deals or contracts between two parties happen on the spot over prevailing market rates.
- Derivative Markets
Two types of commodity derivatives are popular in India. These are futures and forwards. These contracts use spot markets as an underlying asset, which allows individuals to sell or purchase goods at a given time.
What Are Major Commodity Exchanges in India?
Investors need to know well about commodity exchanges in India before participating. Individuals can choose to opt for physical trading or work in contracts.
There are six significant institutes in India where commodity trading takes place. These are
- Bombay Stock Exchange (BSE)
- National Commodity and Derivative Exchange (NCDEX)
- National Stock Exchange (NSE)
- Indian Commodity Exchange (ICEX)
- National Multi Commodity Exchange India (NMCE)
- Multi Commodity Exchange India (MCX)
How to Participate in Commodity Trading in India?
Investors need to follow specific primary steps to participate in commodity trading. The steps to invest may vary among commodities and the marketplace. However, this list highlights the steps needed to trade in commodities.
Step 1: Know about Commodity Trading
This is essential for investing in an unfamiliar market. Investors must be well-informed about the market in which they are investing. Additionally, they should have a clear idea of the factors affecting a particular commodity’s price. With a deeper knowledge, investors can decide whether commodity trading fits them.
Having a fair idea also helps investors to judge their risk appetite and plan strategies accordingly.
Step 2: Choose a Reputable Stock Broker
This step follows after an investor is done with their research on commodity trading. While searching, investors should check if the stock broker has a SEBI registration. This is a precautionary step against fraud and misuse of funds.
Investors must also check the brokerage fees and additional charges before finalising any broker. Furthermore, investors should know about other services provided by these brokers before confirmation.
This marketplace might look chaotic and confusing if you are a novice investor. So instead, seek learned guidance and navigation to decide where to invest your funds.
Step 3: Opening a Demat and Trading Account
This is a mandatory step after an investor finalises a broker. To open a trading and Demat account, an investor must submit their Aadhaar Card, PAN card, bank statement, income proof, and age proof.
This should be a separate account that only serves the purpose of commodity trading. Brokers will analyse an individual’s risk appetite based on applicants’ information. With this analysis, brokers can approve or reject one’s application for a Demat account.
The Demat account will activate instantly once the broker approves your application.
Step 4: Make an Initial Deposit
Investors must make an initial deposit after activating their Demat account. This initial deposit will vary between brokers. However, investors usually make an initial deposit of 5-10% of their contract value.
Investors must also maintain a maintenance margin in their accounts to cover any losses.
Include an example
Step 5: Formulate a Trading Plan.
After setting up your trading account, you should start working on a trading plan. This will help investors to observe and understand the market and plan their bets accordingly.
Creating a trading plan helps you understand your risk appetite and financial capability. As a result, your strategy will become efficient and fit your personal preference. If you are a novice investor , you can seek advice from an experienced investor, but make sure others’ trading styles fit your requirements.
What Are the Advantages of Investing in Commodity Trading?
This list highlights some advantages an investor can enjoy by investing in commodity trading.
- Hedge against Inflation
Although investors fear inflation, this can work well for you when investing with commodities. Price hikes due to inflation positively influence the performance of your commodity investments. It is seen that, in times of high inflation, commodities perform well and robustly.
Prices of commodities used for industrial purposes fall during inflation, unlike stocks. Therefore, investors trade in commodities during inflation to shelter their capital.
- Highly Liquid
The commodity trading markets tend to be highly liquid, which makes selling and purchasing easy and quick. This makes it a safe and secure option to trade compared to other marketplaces.
- Transparent Market
Trading/Investing is quite transparent when it happens with commodity futures. This encourages more participation in this market while ensuring a fair price of products.
- Security against Geopolitical Events
Geopolitical events like international war, civil war, or riots disrupt the demand and supply chain. This further affects the prices of things around us.
Such geopolitical events lead the prices of stocks to sink. However, during periods like this, prices of commodities rise. Hence, investing and trading in commodities help investors and traders to keep bankruptcy at bay.
- Profitable Returns
Because commodities are highly liquid, they can provide an excellent return to investors.
- Shallow Margin To Trade
Investors usually deposit 5-10% of their contract’s total value to their brokers as a margin payment. This happens to be significantly less margin than other securities. Therefore, investors can occupy prominent positions in the market with minimal margins.
What Are the Risks Associated with Commodities?
Besides the above advantages, commodity trading comes with the following risks:
- More Vulnerable to Geopolitical and Economic Events.
Although the commodity market brings good returns during periods of market downturns or high inflation, a commodity investor is very much exposed to this market’s volatility. Therefore, an investor should have up-to-date, accurate information about major political and global issues to survive in this market. This will help them stay prepared when such issues disrupt the marketplace.
- The Market Volatility May Seem Confusing
Experts believe commodity prices are four times more volatile than bonds and twice as volatile as stocks. This may look overwhelming and confusing to new investors. These price discrepancies can lead to miscalculations if one’s a trading/investing plan is inaccurate.
- May Lead to an Over-leveraged Position
The low minimum margin requirements allow investors to trade/invest in commodities. However, such easy access to leverage leads to many investors taking risky bets. When the market goes in an unexpected direction, it can lead to massive losses.
Commodity trading can open the gateway to considerable returns if investors tap into good trading practices. However, one must note that “right trading/investing practice” is subjective. Also, investors must opt for authentic sources to gain insights about this market before investing.
Frequently Asked Questions
- Are commodities good investments?
Like all investments, commodity trading also comes with their shares of risk. For instance, a nation’s geopolitical climate impacts the prices of commodities they produce. This, in turn, impacts its price across the globe. However, commodities provide many unique benefits, including price appreciation during inflation and high liquidity.
- When should I invest in commodities?
There is no set time or season to invest in commodities. You can seek advice from experienced financial advisors on investment strategies or if you are an experienced investor follow the market movements to grab your moment to invest. Many find purchasing commodities before inflation an effective investment strategy.
- What is the most traded commodity globally?
Gold and silver stand as the most traded commodities around the world. Other than these precious metals, copper, natural gas, crude oil, sugar, coffee, and wheat are popular commodities amongst traders and investors.