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Commodities

What is a commodity?

Commodity is a raw material or primary agricultural product that has full fungibility. A fungible asset is one, which can be easily exchanged for another asset or converted into cash. Examples of commodities traded in India are agricultural products (e.g. wheat, paddy, sugar, cotton, spices, oilseeds etc), base metals (e.g. copper, aluminium etc), bullion (e.g. gold, silver), energy (e.g. crude oil, natural gas).

Where can you buy or sell commodities?

You can buy or sell commodities or commodity derivatives (e.g. commodity futures, commodity options) in commodity exchanges. The two main commodity exchanges in India are Multi Commodity Exchange of India (MCX) and National Commodity and Derivatives Exchange (NCDEX). Different types of commodities are traded on these exchanges. Apart from MCX and NCDEX, you can also trade in commodities in the NSE and BSE.

What are commodity futures?

A commodity future is a financial agreement to buy or sell a specified amount of the commodity (e.g. crude oil, gold, copper etc) at a pre-determined price on a specific date. For example, crude oil futures with expiry date of 19th December 2022 are trading at Rs 6,673 per barrel (bbl) in MCX. You buy 100 bbls (crude lot size = 100 bbls on MCX) of crude oil futures at this price. If the spot price (current price) of MCX of crude on 19th December 2022 is Rs 7,000 / bbl, then you will make a profit of Rs (7,000 - 6,673) / bbl X 100 bbls = Rs 327 X 100 = Rs 32,7000. If the spot price of crude oil on 19th December is less than Rs 6,673 bbl.

Commodity futures can also be used for hedging. For example, you buy copper as a raw material in your manufacturing business. Copper futures for 30th December expiry are trading at Rs 692 / kg. You expect copper prices to go higher then you can hedge your price risk by buying copper futures. If price of copper on 30th December is more than Rs 692 / kg, you will pay more to buy raw material, but you will make a profit in your futures position. So your net impact will be lower, depending on how much of your commodity exposure you have hedged. For 100% hedged exposure your impact will be zero.

What are commodity options?

A commodity option is the right to buy or sell a specified amount of a commodity at a pre-determined price on a specific date. A commodity option gives you the right to buy or sell a specified amount of a commodity at a certain price, but you do not have the obligation to buy or sell. If the market movement makes your payoff unfavourable, you have the option of not exercising your right.

The right to buy a specified amount of a commodity at a pre-determined price (known as strike price) on a specific date is known as a call option. If the spot price on expiry is higher than strike price, then your pay-off in call option will be positive before netting off the cost of the option. If the spot price on expiry is lower than strike price, then your maximum loss will be the cost of the option. The right to sell a specified amount of a commodity at a pre-determined price (strike price) on a specific date is known as a put option. If the spot price on expiry is lower than the strike price, then your pay-off will be positive before netting off the cost of the option. If the spot price on expiry is higher than strike price, then your maximum loss will be the cost of the option. The cost of an option is known as option premium.

For example, call option for crude oil at strike price of Rs 7,000 per bbl for 15th December expiry is trading at Rs 128 per bbl in MCX. You buy 1 lot size i.e. 100 bbls of the crude oil call option. If the spot price of crude oil on 15th December is Rs 7,200 bbl then your profit will be (Rs 7,200 - 7,000 - 128) per bbl X 100 bbls = Rs 72 X 100 bbls = Rs 7,200. If the spot price of crude on 15th December is Rs 6,900 then your loss will be Rs 128 X 100 bbls = Rs 1,280.

How to start commodity trading?

You need to have a demat account to trade in commodities. You also need to have a trading account with a broker where the commodities are traded e.g. MCX, NCDEX, NSE, BSE etc. You should trade in commodities, of which you have a good understanding. You should follow the market regularly and consult with your broker / dealer to make informed decisions

Benefits of commodity trading

Commodities are highly liquid asset classes; you can buy and sell commodities based on your needs in commodity markets. But some commodities are more liquid than others.

You can get the benefit of leverage in commodity trading. You can take significant position in commodity markets by paying 5 - 10% to your broker, which is much lower than margins required for equity trading.

Commodity trading is relatively simpler than trading in stocks. In stocks you need to research the fundamentals of individual stocks before investing or trading. On the other hand, most actively traded commodities e.g. crude oil, natural gas, copper, silver, gold etc follow global price trends.

Commodity trading is very convenient. You can trade online using your PC or using your mobile app.