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Things To Keep In Mind Before Starting Commodity Trading

Commodity trading still isn’t as popular for young investors as is the equity market. So, get to know here what it actually is and how you can trade in them.

Commodity trading is less popular among young investors than the stock market.

The formalised online commodity trading market opened in India in 2003, and now retail investors can participate in it too. All they need to do is open a separate commodity demat and trading account with any registered stockbroker.

Foreign portfolio investors (FPIs), except for eligible foreign entities (EFEs), are prohibited from trading in certain sensitive agricultural commodities and other commodity products. But to promote liquidity in the Indian commodity market and to enhance its status, the Securities and Exchange Board of India (Sebi) has proposed to change this rule.

Let us now understand what a commodity is and how one can trade in commodities in India.

What Is A Commodity?

A commodity is a physical good or a product, which has some utility and value in the lives of people. Examples would be – crude oil, mentha oil, cotton, soybean, steel, aluminium, gold, lead, and the like.

A commodity is any raw material or primary agricultural product that can be bought or sold, such as wheat, gold, or crude oil, among others. Commodity trading is the buying and selling of commodities and their derivative products, "says Narinder Wadhwa, national president, Commodity Participants Association of India (CPAI).

A commodity is a product that serves a purpose.

What Are the Ways to Trade in Commodities in India?

There are three popular ways to trade in commodities in India, and you can indirectly invest through mutual funds, too. Commodity traders and businesses that deal in commodities buy and sell commodity futures contracts on stock exchanges due to speculative trades or business requirements, as the case may be.

Read here to learn more about the risks in commodities trading

A commodity exchange is a regulated market where the trading of commodities takes place. The trading takes place in derivatives: futures and options. A futures contract is an agreement to buy or sell a fixed quantity of a commodity at a pre-decided price and within the stated expiry date, "adds Wadhwa.

Here are the three most popular ways to trade in commodities:

Commodity Mandis: Agricultural and other commodities are mostly traded by this method. This is also called the "spot market," where the buyer and seller decide on the spot about the price they are willing to pay for a commodity. In India, the respective states regulate this market and also govern the respective rules regarding the same.

Commodities are often split into two broad categories: hard and soft commodities. Hard commodities include natural resources that must be mined or extracted, such as gold, rubber, and oil, whereas soft commodities are agricultural products or livestock, such as corn, wheat, coffee, sugar, soybeans, among others. A commodity market is a marketplace for buying, selling, and trading such raw materials or primary products, "says Megh Mody, research analyst at Prabhudas Lilladher, a financial services company.

Futures & Options Market: This market is regulated and governed by Sebi. What happens here is that commodity futures and options based on those futures (not spot market prices) are offered for trade by investors. For instance, Crude March Fut is the name of the future contract for crude oil which will expire on March 19. So, investors who will buy this contract will either have to sell it with a loss or profit well before March 19, or take delivery of 100 barrels of crude oil per lot. Almost all commodity traders choose the first option since it is the most practical one, too.

The prices in the commodities futures markets are based on physical spot prices as well as international reference prices of global exchanges, such as NYMEX, COMEX, and CBOT, and have a strong correlation with the conversion of the USD-INR currency pair. This is because the underlying price on these global exchanges is in dollars. Direct global exchange linkages don’t exist in the Indian stock markets yet, "says NS Ramaswamy, head of commodities, Ventura Securities Ltd.

There are various mutual funds available that investors can use in order to gain exposure to various commodities. Some of these could be gold mutual funds, water (aqua) funds, and world resource funds, among others. Since 2019, Sebi has permitted mutual funds to invest in all exchange-traded commodity derivative products, except in a few "sensitive commodity contracts." But they have to square off their position before their contract expiry.

Physical spot prices are used to set prices in commodities future markets.

How Does Commodity Trading Happen on Stock Exchanges?

In commodities trading on stock exchanges, there is no cash spot market, and all trades are settled using futures contracts. There are two options that an investor has when he chooses to trade in commodities on stock exchanges.

He can either take physical delivery of the commodity, or he can convert the commodity future contract into demat mode and settle it using cash for either a profit or loss, depending upon the specific price of the commodity.

Delivery of a Commodity Contract Process

Most commodity traders choose to settle the contracts in cash rather than take delivery of the commodity. For instance, MCX runs a pan-India logistics warehouse; the full list of those can be checked here

The physical delivery of the crude oil futures contract happens at the Jawaharlal Nehru Port in Mumbai. Let’s assume you bought one crude oil futures contract lot and then did not square it off before the contract expiry date. So, now you have to take delivery of this crude oil contract. One single lot of crude oil contracts is 100 barrels. Thus, you can either go to JNPT Port in Mumbai and show them the contract purchase receipt or warehouse/vault receipt, which will show that the said commodity has been purchased by you and is being held in that warehouse. You will also get a tender notice, delivery intention, or delivery order from the seller of this contract with all the necessary delivery details. Now, if you default on buying a commodity, despite buying the contract, the exchange will levy a heavy penalty on you, and you could also face legal charges. The penalties are different for different commodities.

Read more about it here in detail

"If one prefers to convert the position of a commodity futures contract into delivery, the methodology is different. Unlike in the stock market, where the delivery is in the form of a dematerialised electronic mode, in commodities markets, the delivery is physical (tangible), or one could have it credited into their dematerialised electronic mode and settle it for cash. In the commodities market, we have warehouse logistics being referred to as "tangible physical delivery," adds Ramaswamy.

How Are Commodity Margins Calculated?

Let’s suppose you want to trade in crude oil futures. A lot of crude oil futures contracts are made up of 100 barrels.So, for intraday trading (9 a.m. to 11.55 p.m.), you'll need 50% of SPAN.SPAN is the Standard Portfolio Analysis of Risk. It is calculated by the stock exchanges using the price and vitality of the respective stock or commodity on that specific day and is revised throughout the trading session of the respective stock or commodity.

If you wish to hold this in your demat account for carrying forward with the trade, then you will need 100 per cent of the SPAN money, i.e., you will have no leverage.

You can read in detail about how stock exchanges calculate SPAN.

As of 2.03 pm on March 26, a crude oil April future lot would require Rs 2,34,176.25 cash as SPAN and risk adjusted margin for carrying it overnight (delivery demat), while one lot would cost Rs 8,621. Whether your broker collects the entire SPAN and risk exposure margin or not is completely up to their discretion.

Some brokers, for example, collect the full 100 percent SPAN + Exposure margin upfront, even for intraday trades.See your respective broker’s policy regarding this.

While trading, if your total cash balance falls short of SPAN margin requirements, you will get margin calls from your broker. When you get intimations like these, you can either close the trade with a loss, or you can deposit additional money in your trading account and continue to hold the respective trade.

Read here to know more about margin requirements while trading in derivative products like futures and options

Where Does Online Commodity Trading Happen?

Four national commodity exchanges operate in India, and they are all regulated by Sebi. They are, namely, the Multi Commodity Exchange of India Ltd (MCX), the National Commodity and Derivative Exchange (NCDEX), the National Stock Exchange (NSE), and the Bombay Stock Exchange (BSE).

The commodity online trading markets are open in India from 9 am to 11.55 pm (November-March) and 9 am to 11.30 pm (March to November), Monday to Friday.

The market timings were intentionally kept like this so that the price of the respective commodity could be discovered in a way that is in sync with the US and European prices. These timings are kept in sync with the US Daylight Savings time system, as well, and hence the additional 25 minutes of trading time from November to March.