23 points you must know about the basics of commodities trading
The commodity derivatives (such as Commodities Futures etc.) provide new avenues for retail investors and traders to participate beyond equities, bonds and real estate. This separate asset class provides a classic opportunity for market-savvy investors, arbitrageurs and speculators to participate without actual physical possession of the assets.
Let’s have a look at the most important and most basic key points that you must know about the commodities trading:
#1. Different assets variables that are successfully traded in commodity exchanges are as follows:
- Agricultural commodities – including cocoa, coffee, corn, cotton and rice, soybeans, sugar, wheat.
- Energy commodities – including crude oil, gasoline, heating oil, and natural gas.
- Livestock and Meat commodities – including feeder cattle, lean hogs, live cattle and pork bellies.
- Metals commodities – including copper, gold, platinum and silver.
#2. Commodity Exchange traded funds (Commodity ETFs) use futures contracts to monitor or track price of particular commodity or group of commodities that form an index. In the same manner, Commodity exchange traded notes, or Commodity ETNs, are unsecured debt instruments designed to mimic the price fluctuation of a particular commodity or commodity index, that are backed by the issuer. An investor does not require special brokerage account to invest or participate in commodity ETFs or commodity ETNs.
#3. A categorical market estimate, puts turnover of commodities market, to about 58 percent of nation’s GDP. Presently, the various commodities across the country markets clock an annual turnover of Rs 1,40,000 crore equivalent to Rs 1,400 billion INR.
#4. One can trade in commodities by registering a commodity trading account in one of the three commodity exchanges – the Multi Commodity Exchange of India Ltd (MCX), the National Commodity and Derivative Exchange (NCDEX), and the National Multi Commodity Exchange of India Ltd (NCME). NMCE has most major agricultural commodities and metals under its fold, the NCDEX, has a large number of agriculture, metal and energy commodities. MCX also offers many commodities for futures trading.
#5. Commodities can be traded in three ways in commodity markets
1) buy/sell commodity in future market
2) buy commodity in physical format
3) buy commodity in demat format
#6. To open commodity trading account, you need to provide Know Your Client form, PAN no., bank account no, and an agreement to set the terms and conditions shared in between exchange and registered commodity broker such as ICICIcomm trade (ICICIdirect), ISJ Com desk (ISJ Securities), Refco Sify Securities, SSKI (Sharekhan) or Sunidhi Consultancy etc.
#7. All the three commodity exchanges have both systems – cash as well as delivery mechanism.
#8. A buyer can have contract cash settled, by indicating the same at the time of placing the order, that delivery is not intended for commodity item. A trade can be booked for delivery, by having required warehouse receipts. The conversion option between cash and delivery settlement can be exercised as many times, till the last day of the expiry of the contract. The market mediates between buyers and sellers of commodities, and facilitates decisions related to storage and consumption of commodities.
#9. To invest in commodity markets, you can start with as low as Rs 5000. This is utilised towards payment of margin money, ranging between 5-10 per cent of the value of the commodity contract. In commodities also, the margin is calculated by value-at-risk, VaR system. This is paid as upfront to exchanges through brokers. The margin is different for each commodity. In commodities trading with commodities exchange, there is a system of initial margin and mark-to-market margin (MTM margin). The margin keeps changing, depending on the change in price and volatility.
#10. For trading in bullion, that is, gold and silver, the minimum amount required for trading of gold is – one trading unit 10g, which is base price per 10g of gold, estimated on market price of gold bullion. Similarly, the minimum amount required for silver for one trading unit 10g, is base price per 10g of silver, estimated on market price of silver bullion.
#11. The prices and trading lots in agricultural commodities varies from one commodity exchange to another. However, again, the minimum funds required to begin commodity trading in agricultural commodities will be approximately Rs 5,000.
#12. The brokerage applicable on commodities varies for different commodities. The brokerage charges in commodity trading range from 0.10-0.25 per cent of the contract value. The Transaction charges range between Rs 6 and Rs 10 per lakh/per contract. Brokerage also differs based on trading transactions and delivery transactions. A point of difference on brokerage applicable in contract resulting in delivery with an applicable brokerage of 0.25 – 1 per cent of the contract value. Also, the brokerage cannot exceed the maximum limit specified by the exchanges.
#13. Stamp duty is only applicable in delivery contracts and is in accordance to the prescribed laws, of the state, where the investor trades in. Also, no stamp duty applicable for commodity futures that have contract notes.
#14. The physical delivery of commodity is liable to sales tax applicable at the place of delivery and credited to sales tax registration number. A squared off trade generates no sales tax.
#15. The concept of circuit filter is also applicable to commodity market, is variable and with maximum threshold of 6 percent. A deviation either way beyond its limit, results in circuit breaker.
#16. The commodities market will have three broad categories of market participants apart from brokers and the exchange administration – hedgers, speculators and arbitrageurs. Brokers are intermediate functionaries, facilitating hedgers and speculators.
#17. Hedgers are essentially players with an underlying risk in a commodity. A hedger may be either a producer or consumer who may want to transfer the price-risk into the market.
#18. Producer-hedgers are those who want to mitigate the risk of prices declining by the time they actually produce their commodity for sale in the market and the consumer-hedgers are those who would want to do the opposite.
#19. The functioning of commodity exchanges is regulated by the Forward Markets Commission (FMC). The commodity brokers are not required to register themselves with the regulator. The FMC deals with exchange administration and will seek to inspect the books of brokers if foul practices are suspected or if the exchanges fail to take action.
#20. The commodity futures and hedging practices, help to moderate volatility in commodities, and prevent bankruptcies for businesses, that require predictability in managing their expenses. This fact helps manufacturers and service providers to reply their budgeting processes on commodity market prices. In-turn these businesses are able to reduce a lot of cash flow-related conditions and normalize expenses through the use of forward contracts
#21. If the value of the contract goes down, you will be subject to a margin call and will be required to place more money into your account to keep the position open. Due to the huge amounts of leverage, small price movements can mean huge returns or losses, and a futures account can be wiped out or doubled in a matter of minutes.
#22. Retail investors need to understand the risks and advantages of trading in commodities futures, before taking a leap into commodity trading. Historically, pricing in commodities futures has been less volatile compared with equity and bonds. This is basis for an efficient portfolio diversification option. The risk-averse investors can create nice returns by trading precious metals. Precious metals such as gold have been used for longer duration as a hedge against high inflation or periods of currency devaluation. Alternatively, in unusually volatile or bearish markets, influx in commodity prices can provide opportunities to park cash.
#23. Population growth, combined with limited agricultural supply, provide better opportunities to ride agricultural price increases. The demands for industrial metals can also lead to opportunities to make money on future price increases.
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