Intro to Commodities
Welcome to the chapter on Commodities and Commodity Trading.
Let’s start from the basics so you have an idea of what it is, why it is necessary and what happens when you engage in Commodity Trading.
Before we do so, here are our recommended brokers who can help you invest in commodities. We suggest you check each one and try at least 2 of them for a few months before you pick one platform for all your investments.
What are Commodities?
Commodities refer to basic movable goods of the primary economy that can be bought and sold and include agricultural products, base metals (aluminium, copper, zinc, etc.), bullion (gold, silver, platinum) and energy (oil and natural gas).
It is used in commerce and is interchangeable with other goods of the same type.
Note: The primary economy refers to all industries involved in the extraction and production of raw materials and includes farming, forestry, fishing and mining.
These commodities are traded on different exchanges called commodity exchanges primarily through derivatives such as futures, options and swaps.
The two primary exchanges of the country, BSE and NSE, offer commodities trading. In addition, there are six national commodity exchanges:
- Multi Commodity Exchange (MCX)
- National Commodity and Derivatives Exchange (NCDEX)
- Indian Commodity Exchange (ICEX)
- National Multi Commodity Exchange (NMCE)
- ACE Derivatives Exchange (ACE)
- Universal Commodity Exchange (UCX)
All the exchanges are regulated by the Securities and Exchange Board of India (SEBI).
Investing in Commodities
The easiest way to invest in commodities is through a futures contract.
As we discussed in the previous chapter on derivatives, a futures contract is an agreement to buy or sell a specific quantity of a commodity at a predetermined price in the future.
Traders use these contracts to reduce risks associated with the price fluctuations of future prices of commodities. Let us repeat the example we discussed in the chapter on derivatives so you can understand better how it works.
Imagine a food processing company needing wheat at a certain date after 1 month. The company management may have reasons to believe that the price of wheat will rise after a month. So, they will try to enter into a contract with a seller of wheat to buy the wheat from them at the current price but take the delivery later.
The seller, on the other hand, may think that the price of wheat may fall and may want to enter into a contract right now and fix on the current price so that they do not suffer a loss.
Here, both the buyer and the seller stand to gain as the buyer is buying wheat to be delivered at a future date at the current price (which they expect to rise), and the seller is selling at the current price (which they expect to fall).
In addition to such commodity traders or companies, other investors include speculators.
Speculators are seasoned investors who purchase the commodities for a short period of time and use strategies that allow them to profit from the changes in the price of futures contracts. Unlike companies, these investors do not take delivery of the commodity and therefore close out their positions before the futures contract becomes due.
An easy way to invest in commodities is through Exchange Traded Funds (ETFs).
Exchange Traded Funds (ETFs)
Commodity ETFs are a type of exchange-traded funds which invest in commodities instead of stocks or bonds. Usually, they focus on one commodity or a specific group of commodities like gold or metals respectively. They may make investments in futures contracts also.
However, in India, the only ETFs available at the moment are Gold ETFs. And so, investors have limited options besides futures contracts.
Though SEBI has given the guidelines for the formation of commodity indices on 18 June 2019, commodity ETFs are likely to be launched once the index providers make available these robust multi-commodity indices. But as mutual funds are focusing on launching multi-asset allocation schemes with exposure to commodities, the launch of commodity ETFs may be a bit further off.
As of now, mutual funds are allowed to trade in commodities through exchange-traded commodity derivatives (ETCDs) but cannot take exposure to a physical commodity except in the case of gold ETFs.
Exchange Traded Notes (ETNs)
There is a concept called commodity Exchange Traded Notes (ETNs) that are not available in India but available abroad for investors.
These ETNs are senior, unsecured, unsubordinated debt issued by an underwriting bank that trades in the commodity futures. They are similar to other debt securities and have a maturity date. ETNs are designed to give investors access to the returns of various market benchmarks to which they are pegged.
ETNs are however quite opaque. They may be riskier than ordinary unsecured debt securities and may not have principal protection. The investor may lose their entire principal also if the futures do not perform as the underlying bank had planned.
Risks of Commodity Trading
There is one important thing that you need to remember: trading in commodities is risky.
This is because unlike a stock whose future price movements you can likely gauge from its past performance, the same does not apply to commodities. Supply and demand in the commodities market are impacted by uncertainties that are difficult or impossible to predict.
You need to be aware of the macro environment and economic policies to start with. There are numerous other things you will have to track such as the weather patterns, the time of the monsoons, the agricultural crop (if you invest in agricultural commodities), production of base metals, legislation, state polices and much more.
Moreover, commodities trading works on margin trading which can be risky for unseasoned investors. You need to put in more money to get the same returns as what equity can provide.
Understanding Margin Trading
I will explain why margin trading exists in futures contracts in a very simple way so you get the basics.
Margin trading exists because investors have the option to magnify their income by a significant amount as compared to cash trading. The margins are usually decided based on the volatility of the stock or the commodity.
In margin trading when you trade, you are promising to pay the other party a specific amount but you don’t have to put in all the money right away as the broker allows you to bid for contracts over and above the funds or value of the securities you have at hand (called the Margin) by giving you a loan. You have to pay off this at a future date. You also need to top off the margin you have to keep with the broker (called Maintenance Margin) when it falls below a specific level.
Let us look at an example to understand why margin trading is more lucrative for investors.
Suppose a stock has a margin of 20% and its current market price is Rs. 10.
This means you can buy one share of the stock on margin trading by only putting in Rs. 2 (20% of Rs. 10).
So if you have an investment of Rs. 2 lakh, you can buy 1 lakh shares of the stock on margin trading. If you do not go for margin trading and instead go for cash trading, you get only 20,000 shares for Rs. 2 lakh.
Now, if tomorrow, the market price of the stock goes up to Rs. 12 from Rs. 10, you will gain Rs. 2 lakh on the 1 lakh shares you have. In cash trading, you will gain only Rs. 40,000.
Even after deducting all expenses and charges for margin trading, you still earn more with margin trading than with cash trading.
Margin trading is an integral part of commodities trading as unlike share prices that move up and down quite significantly, commodities do not go up or down 10-20% on a regular basis. They are more likely to move up or down 2-3%.
This means an investor has to pump in a lot of money to have a good income. And since an investor would not have that much money to keep in a futures contract on a regular basis, they will engage in margin trading so they can profit more by putting in the margin money.
This is why futures contracts are leveraged.
An Axis Bank research shows that 10% exposure to commodities and 90% exposure to equities between 2007 and 2019 gave similar returns to a pure equity portfolio but with much lower volatility.
Nonetheless, the risks associated with commodities remain. In addition to uncertainty, the need to put in more money than what you would in equity or other market regulated investment options. On top of that beyond the top 6-7 commodities that have globally benchmarked prices, the liquidity in the market drops off.
So if you are just starting out in the world of investing, we suggest that you avoid commodities altogether. And if or as and when you start, looking at multi-asset allocation schemes or gold ETFs at first and then at futures once you get a hang of the market is a good idea.