What are commodities?
Commodities refer to primary goods or material which can be bought or sold freely for the purpose of trade and commerce. These are essentially non-manufactured goods which either exist naturally, or can be grown naturally, and can serve as an input for the secondary market (manufacturing sector). Trading in commodities is a practice that dates thousands of years back, when agricultural goods were exchanged in barter. With the introduction of currency, there came a standardization in the cost of commodities and this ensured that every commodity/produce was estimated accurately for value. Commodities could be broadly classified into three categories:
- Agricultural produce; like rice, wheat, sugar, etc.
- Natural Resources; like precious metals, base metals, natural gas, petroleum, etc.
- Livestock; like cattle, poultry, dairy,
Challenges faced by commodities markets
An organised system of buying and selling commodities through institutions came much later across the world. Forming of exchanges and regulatory bodies happened in the 19th century in the western world and the latter part of the 20th century in India.There were many challenges in institutionalizing the commodities markets in the world.
- Standardization was very difficult. Agricultural produce varied in quality and would have to be categorized into different grades. Centralized trading required goods to be fungible. Even in natural resources like metals, different qualities needed to be segregated for trading.
- Outreach was limited: Providing timely transporting and warehousing facilities to access commodities in the entire geographical expanse of the marketwas a big challenge. Establishing this inclusivity was even more difficult for perishable goods like agricultural produce.
- Financing facilities were not available for small producers and traders, who mainly relied on their own money instead of credit supply. Many poor farmers looked for instant conversion of goods to cash for sustenance and did not have any capacity to wait for the right prices. They were hence not able to take full advantage of the commodities markets.
- There was a lack of regulation. Proper regulations and guidelines for commodities trading were not established and evolved until much later, and this led to exploitation of smaller investors and producersby the bigger players.
However, the commodities market underwent significant changes over time and today there is a vibrant and integrated market for commodities trading all over the world.There are close to 50commodity markets in the world dealing in roughlyover a hundred primary commodities. In India, there are three national exchanges and 24 regional exchanges that allow trading in around sixty commodities.
Participants of Commodity trading
There are primarily two main functions of commodity trading which attract investment
- Hedging: Hedging is done by consumers of the commodity, who wish to lock-in their profits at a predetermined price. For example, a manufacturing unit XYZ has purchased 1000 tonnes of copper as raw material. It fears that the prices of copper may fall in the future, and reduce the value of their inventory. To prevent this, XYZ sell copper futures on the commodity exchange. In case the prices of copper actually fall, they can sell copper at the predetermined price via futures contract. In case the price of copper increased, they would make a loss on the short position, but it would be offset by the increase in the value of their inventory.
- Speculation: Speculation is the opposite of hedging where the hedger can pass on his risk to the speculator. Speculators look for making profits from the price changes of the underlying commodity by betting against the hedger. Futures market allows the speculator to trade on margins to multiply their returns from the commodity. For example, if an investor believes that the price of silver will increase, he can buy physical silver but he will have to pay 100% of the value to the shopkeeper. But, in futures market, he can invest only 5%-7% of the value of the contract. This way he can gain 15-20 times more exposure with the same amount of money, and resultantly his profits or losses would also multiply.
Commodity Trading in India
In India, there are two types of markets for commodity trading – Spot Market and Derivatives Market
Spot Market is where the trade takes place in cash and the delivery is made immediately. This market is prevalent in the retail segment which is still unorganized. This market is regulated by bodies like Agricultural Produce Market Committee (APMC) for agricultural commodities, other local market associations, etc.
Derivatives Market is where the trade takes place in the form of a future/option/swap contract. Here, the transaction is done at a future date on an agreed price, on the basis of future price prediction by exchanging parties. The Futures contracts are mainly used for price protection, hedging and speculation, and rarely for taking physical delivery of the commodity. The investors usually agree to partake in the profit or loss arising from the contract price verses the spot price on that day. These markets are organized and regulated by the SEBI.
Commodity Exchanges in India
There are 3 national level commodity exchanges present in India
- Multi Commodity Exchange (MCX)
- National Commodity and Derivatives Exchange (NCDEX)
- National Multi-Commodity Exchange (NMCE)
Out of the three exchanges, MCX forms a larger part of market with close to 90% market share.
These exchanges fall within the regulatory ambit of SEBI and ensure that there are no discrepancies in the standards of trading and settlement. The exchanges facilitate spot and futures trading in agricultural commodities, base & precious metals and energy. In the spot market, the prices of commodities are determined by demand and supply mechanism;however, the futures prices behave similar to equities which witness bull and bear cycles and traders taking positions based on their expectations of market trends.
- What are the commodities traded in Indian markets?
Following are the commodities traded on MCX, the largest Commodity Exchange in India.
Gold Petal (New Delhi)
Crude Oil Mini
Brent Crude Oil
Crude Palm Oil
- How can I trade in commodities?
You can trade in commodities by opening an account with a commodity broker registered with any of the commodity exchanges. These brokers are listed on the websites of individual commodity exchanges. You can also open an online account with the broker to execute trades on your own.
- What are the margin requirements for trading in commodity futures?
There are 3 kinds of margins applicable when trading in commodity futures on MCX
- SPAN: Standardized Portfolio Analysis of Risk (SPAN) Margin is the initial margin applicable to start trading on MCX. It is calculated on the basis of the risk and volatility of the underlying commodity. This keeps changing according to the specific commodity price fluctuation.
- Commodity Exposure: This is over and above the SPAN margin, calculated on the value of exposure in the commodity. It usually remains a fixed amount.
- ELM: Extreme Loss Margin of 1% is applicable on all commodities to cover the expected loss in situations that lie outside the coverage on SPAN margin. While SPAN margin can cover the largest loss on 99% of the days, ELM margin covers the maximum loss on 1% of the days.
- How are commodities contracts settled?
Commodity contracts can be settles either by cash or by physical delivery of the underlying. However, this would involve transportation, warehousing and documentation. To avoid such hassles, most commodities contracts in India are cash settled.
- Which are the most traded commodities in India?
Some of the most actively traded commodities on MCX include
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