Commodities are basic physical stuffs, or you can call them resources, which we use as raw materials.For example, gold- we use gold to make jewelry, cotton- used to make clothes, rice and dals- used to cook food. As consumers, we do not trade in them. We just buy and consume, use it. However, as we know there are people who buy and sell them further for profits.
The returns from investing in commodities is based on the price fluctuation of therespective commodity. Unlike shares and debentures, there is no additional dividend or interest income here.The way we hold equity and debt securities for longer period for better yields, holding commodities means more storage expense. Not to forget, to transfer the ownership of this investment requires transportation costs too.
Traders buy commodities from farmers or other traders and sell them to consumers or other traders in the market at a higher price. However, most of the commodity investors avoid the physical commodity market, because of the extra expense and risk in handling them. They trade in commodity derivatives.
Although Commodity Derivatives include forward and futures contracts both, the underlying asset of which is a particular commodity or commodity index, only Futures are traded on the exchanges.
Only, a small limited group of peopleparticipate in the actual physical supply chain of commodities. However, there are investors (not part of the physical supply chain) who just buy commodities that are non-perishable, highly valuable against their weight/ volume and low-cost storage. Gold and Silver are two great examples of this.
Where to trade
Retail investors can buy and sell commodity derivatives from their brokers who are members of respective commodity exchanges. We can call our brokers or punch orders ourselves with access to online trading. But what’s most important here is to know what are we buying,
- Commodity exchanges: MCX and NCDEX are two major commodity exchanges of India. In all there are 24 Commodity Exchanges in India.
- Regulator: Forward Market Commission (FMC) regulates the commodity futures market.
Examples of Commodities traded in MCX exchange
Broadly, commodities are classified under the following categories:
- Bullion/ Precious metals
- Base metals (industrial metal)
Additionally, each commodity is classified according to its location, grade or quality. For example, under Gold there are Gold, Gold Global, Gold Guinea, Gold Mini, Gold Petal, Gold Petal Delhi.
Again, each of these sub-commodity contracts vary according to the contract specifications like lot size, maturity date, etc. Some real example of gold contracts which are traded in MCX exchange are GOLD which is for 1 kg of gold, GOLDM which is 100 gram contract. You can purchase these on the exchange once you have opened account with commodity broker. For buying these, you don’t need to put in the full money but you can buy by proving a margin of about 10%.
Why do people trade in commodities?
The motive behind initiating commodity derivatives was to hedge against the risk of physical commodities. A simple hedging can be explained by the following example:
A farmer grows wheat and expects 10kg of production in a months’ time. The market price of wheat today is Rs. 50 per kg. By the time the production is ready, the farmer fears that the price may fall. To hedge this, he goes to the market and deals with a trader. He enters into a contract to sell 10kgs of wheat at Rs. 50 per kg. Now even if the price falls, the farmer will receive Rs. 50.
The trader, on the other hand fears that the price may rise and thus locks the price at Rs. 50.
This is a very simple example just to understand hedging. In reality, hedging and commodity trading involve complex contracts and strategies. Companies hire professional hedgers to manage their risk. In our above example, flour making or biscuits and bread making companies use wheat contracts for hedging purpose.
Other than this, people trade in commodity markets to speculate and earn profit from price fluctuations, without entering the physical commodity market.
Commodity derivatives attract investors also for effective portfolio diversification purposes.
You can know more about Top commodity broker in India here.