Finance

Commodities Trading

Commodities Trading

Commodity trading is an investment strategy that includes the buying and selling of goods called commodities which include oil and gas, metals such as gold and silver, and soft commodities like cocoa, coffee, wheat, and sugar. It includes physical and derivative trading using the spot price, forwards, futures, and options on futures. It is a trading platform where investors speculate on the trend of the prices of the commodities to generate profit if the price moves in their favor.

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A commodity is a raw material or an agricultural product that can be bought and sold or exchanged for products of similar value such as sugar, gold, coal, corn. They are classified into two types: Hard and Soft Commodities.

Hard Commodities:

  • Typically, natural resources that are extracted such as gold, oil, etc.

Soft Commodities:

  • Agricultural products or livestock such as corn, wheat, coffee.
  • These goods are the goods that are used as inputs into the manufacture of the other goods, for example, wheat is used in the manufacture of flour.

Background on The Commodities Trading:

Commodities trading began back in history in India, long before it began in several other countries. However, invasions and rulings by foreign nations, natural catastrophes, and several regulatory frameworks, and their reforms, were major factors behind the decline in commodities trading. Today, even though there are various other forms of the stock market and share market traders, commodity trading has regained its importance.

It began around the same as that of the U.K and U.S.A. Commodity markets in a crude early form have originated in SUMER between 4500BC and 4000BC. In those times crude was used for trading and was exchanged for other goods and commodities or for payments of labor. Sumerians first used clay tokens sealed in a clay vessel to represent the amount. These promises of the time and date of delivery resemble futures contracts.

Types of Commodities:

1.Energy: Energy is a basic requirement for human survival. Whether it is in the form of electricity, fossil fuels, or renewable natural resources. Among the most heavily traded commodities in the last century were energy products like oil, natural gas, and electricity.

 2.Metals: Metals like gold and silver have been used for centuries as money. Metals have also been used extensively for industrial and commercial purposes. Have a look around yourself and it will be difficult to find a room or even an open space where no metal has been used. Metals have a highly liquid market that is global in nature providing investors with a lot of opportunities to trade and exploit the arbitrage opportunities as and when they arise.

3.Agricultural Produce: Agricultural produce is also a highly traded commodity. Businesses hedge their potential exposures to agricultural products in commodities markets. Agricultural products however are mostly traded in the futures market. There is a drawback to agriculture products in that they cannot be preserved for a very long time because their shelf lives are limited. But commodity markets around the world are as developed as they can be purchased and sold without any issues including with perishable goods.

4.Livestock and Meat: Livestock and meat commodities include live cattle, lean hogs, pork bellies, and feeder cattle.

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Characteristics of Commodities:

1.Fungible: The foremost characteristic of commodities is the fact that they are fungible. It, therefore, implies that, without any decline in value, one unit of any commodity can be substituted for another unit of the same commodity. For example, 1 kg of wheat can be substituted for another 1 kg of wheat without much decline in value. Units that are not fungible cannot be referred to as Commodities.

2.Tradable: It is also essential that commodities must be tradable. Several commodities are quoted directly on the exchanges and can therefore be traded. Consider the case of Brent or Nymex crude oil which can be purchased and sold, hence it is extremely tradable on an exchange. Consider a commodity like plutonium, on the other hand. They are not listed on an exchange directly and thus cannot be traded.

3.Deliverable: Since commodities are being traded, they also need to be deliverable. Commodities like oil and food grains can be delivered to the buyer. Hence, they are considered to be commodities.

4.Liquid: The most essential feature that makes any commodity tradable is liquidity. Liquidity implies that at any specific period of time a few people buy into and out of these commodities. For these commodities, therefore, there is often an engaged marketplace, and prices are quoted. Any person can virtually buy or sell an unlimited amount of these commodities at very short notice. The existence of an effective secondary market ensures liquidity which is a requirement for any form of financial exchange.

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Where to Invest in Commodities?

In India, there are six major commodity trading exchanges as listed below.

  1. Multi Commodity Exchange – MCX
  2. National Commodity and Derivatives Exchange – NCDEX
  3. National Multi Commodity Exchange – NMCE
  4. Indian Commodity Exchange – ICEX
  5. Ace Derivatives Exchange – ACE
  6. The Universal Commodity Exchange – UCX

In 2015, the regulatory body of the commodities trading – Forward Market Commission (FMC) merged with the Securities and Exchange Board of India (SEBI). Commodity trading requires a standard arrangement in compliance with the instructions in these exchanges in order to carry out transactions without any visual examination.  In general, commodities are classified into four types:

  1. Metals – Silver, Gold, Platinum, and Copper
  2. Energy – Crude oil, Natural gas, Gasoline, and Heating oil
  3. Agriculture – Corn, Beans, Rice, Wheat, etc.,
  4. Livestock and Meat – Eggs, Pork, Cattle, etc.

How to Trade in Commodities?

  1. Choose Your Market – Select the commodity you want to spread bet or trade CFDs on, such as Crude Oil Brent, Gold, or Natural Gas.
  2. Decide to buy or sell –Buy (go long) if you think prices will rise, or sell (go short) if you think prices will go down.
  3. Enter a trade size –Decide what amount of CFD you want to trade by the movement of each point (spread betting). The value of one unit can vary depending on the instrument you have selected to trade with when you trade CFD.
  4. Manage your risk – Select from a range of stop-loss orders including guaranteed stop-loss orders (GSLOs). They operate just the same as normal stop-loss orders, apart from that for a premium, they ensure that you will be closed off at the price you specify, irrespective of market fluctuations or gaps. When the GSLO is not triggered, the premium is reimbursed entirely.
  5. Monitor your position –Monitor your open positions (including any stop orders or take profit orders) after placing your trade to achieve your real-time profit or loss. Please remember that losses can exceed your deposits.
  6. Close your position – If your trade is not immediately terminated due to a stop or take profit order which is triggered, close your trade when you’re ready.

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Who Trade in Commodities?

We can distinguish different market participants in the commodity market. We can split market participants into three categories:

1.Hedgers: They are commercial traders whose role in the market is to manage spot market risk.

2.Speculators: They are the ones who speculate on the direction of future prices with the main goal to make a profit.

3.Arbitrage: They seek to buy and sell the commodities to profit from the price differential across different markets.

Final Thoughts:

Commodities Trading depends on factors such as irregularity of monsoon, domestic and international government policies, technologies, natural calamities, etc. Hence it is advised that a person should only have a limited portion of commodities in their portfolio.  For investing in commodities, a person must understand the factors impacting a particular commodity’s price. To become a skilled commodity trader, you need to know all the commodity strategies and have a day-to-day market and economical knowledge.

Author- Moksha Gala

About the Author- Currently, a graduate in the field of accountancy and finance. Commerce has been a part of my life now. Exploring the available choices, finance was always distinct among them. Credits, investments, and markets were always a part of my interest. So decided to embrace finance as a career for life.

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