A right mix of commodities and equity in your portfolio can help you benefit from attractive returns, while reducing the risk component
The Indian investment market offers a lot of investment avenues. Most of us usually invest in bank fixed deposits, PPF (Public Provident Fund), recurring deposits, insurance, bonds, etc. A few of us—who are market savvy—also invest in shares. For those who want to diversify their portfolios beyond shares, commodities are one of the best options.
Commodities offer immense potential to become a separate asset class for market-savvy investors. Most investors consider investing in commodities as quite risky and complicated. But commodities are easy to understand as far as fundamentals of demand and supply are concerned. Retail investors should understand the risks and advantages of trading in commodities before making huge investments. Historically, pricing in commodities has been less volatile compared with equity and bonds, thus providing an efficient portfolio diversification option.
Brief history of commodity trading
The modern trade in commodity futures could trace its origins back to the 17th century in Osaka, Japan, there is evidence to suggest that a form of futures trading in commodities existed in China 6000 years earlier. Organized trading on an exchange started in 1848 with the establishment of the Chicago Board of Trade (CBOT).
The first milestone in the 125 years rich history of organized trading in commodities in India was the constitution of the Bombay Cotton Trade Association in the year 1875. India had a vibrant futures market in commodities till it was discontinued in the mid 1960's, due to war, natural calamities and the consequent shortages. The advent of economic liberalization helped the cause of laying emphasis on the importance of commodity trading. By the beginning of 2002, there were about 20 commodity exchanges in India, trading in 42 commodities, with a few commodities being traded internationally.
Commodities can be classified into five key sectors: Agriculture, metals and materials, precious metals, energy and services. Agri-commodity comprises of soybean, pepper, coriander, turmeric, etc; while bullion comprises gold and silver. Energy includes crude oil, natural gas, furnace oil and Brent crude among others, whereas metals consists of copper, lead, aluminum, zinc, nickel, etc.
Grains: Rice, Basmati rice, wheat, maize, jeera.
Oil and oilseeds: Castor seeds, soy seeds, castor oil, refined soy oil, soymeal, crude palm oil, groundnut oil, mustard seed, cottonseed, etc.
Spices: Pepper, red chilli, jeera, turmeric and cardamom.
Pulses: Chana, urad, yellow peas, tur dal.
Metals and materials
Base metals: Aluminum, copper, nickel, zinc, tin.
Bulk commodities: Iron ore, coking coal, bauxite, steel.
Others: Soda ash, chemicals, rare earth metals.
Precious metals and materials
Gold, silver, platinum and palladium.
Crude oil, natural gas, Brent crude, thermal coal, alternate energy.
Oil services, mining services and others.
Spot and future prices in commodities
Spot price is that price in the cash market where one buys and sells goods “on the spot”, while futures prices are prices of the same commodity at a future date.
For instance: If the spot price of gold is Rs. 14,700 per 10 gm today, the one-month futures price could be Rs. 14,800, whereas two-month futures price could be Rs. 14,950. The difference between spot and futures prices is the cost of carry i.e. interest cost, storing, insurance, etc. Generally futures prices are higher than spot prices.
At present, the regulator Forward Markets Commission allows futures trading in around 120 commodities. India has 22 commodity exchanges which have been set up under the overall control of Forward Markets Commission.
To trade in commodity futures, usually there the main exchanges—Universal Commodity Exchange, National Commodity and Derivative Exchange (NCDEX), Multi Commodity Exchange of India (MCX) and National Multi Commodity Exchange of India. All three have electronic trading and settlement systems and a national presence. As of now you will need only one bank account. You will need a separate commodity demat account from the National Securities Depository to trade on the NCDEX just like in stocks.
What is commodity futures contract
A commodity futures contract is a commitment to make or accept delivery of a specified quantity and quality of a commodity during a specific month in the future date at a price agreed upon when the commitment is made. It is an agreement to buy or sell a set amount of a commodity at a certain time in the future at a certain price.
Commodity futures contract is a standardised contract set by a particular commodity futures exchange that includes the size (1,000 barrels, 5,000 bushels, 5,000 ounces, etc), the place where delivery can be made, the type and quality of the commodity to be delivered, and the price of the transaction.
Commodities traded in the commodity exchanges are required to be delivered at the contracted price, ignoring all the changes in the market prices. Commodity futures contract is one of the avenues for retail investors and traders to participate. Trading in commodity futures contracts can surely be very risky for the inexperienced. It is generally believed that most investors lose money in commodities’ futures. This happens only when market participants do not trade with discipline and fall victims to greed and fear.
How it works
When you buy a futures, you don’t have to pay the entire amount, just a fixed percentage of the cost. This is known as the margin.
For example: You bought gold futures contract at Rs. 72,000 per 100 gm.
The margin for gold set by MCX is 3.5%. So you end up paying Rs. 2,520—also called margin.
The low margin means that you can buy futures representing a large amount of gold by paying only a fraction of the price.
The next day, the price of gold rose to Rs. 73,000 per 100 gm.
Rs 1,000 (Rs 73,000 - Rs 72,000) will be credited to your account.
The following day, the price dips to Rs. 72,500.
Rs. 500 will get debited from your account (Rs. 73,000 – Rs. 72,500).
Choose a broker
To trade in commodities, you need to select a broker. Several already-established equity brokers have sought membership with NCDEX and MCX and are already offering commodity futures services. Some of them also offer trading through the Internet just like the way they offer equities. You can also get a list of more members from the respective exchanges and decide upon the broker you want to choose from.
Transaction in commodity futures
A transaction in the commodity futures market is made electronically on the commodity exchange between brokers. The seller will have a broker, and buyer will have a broker. They will then transact an order for a purchase and sale. The buyers and sellers of commodity futures contracts have obligations. The buyer is obligated to take delivery and pay for the cash commodity during a specific time frame. The seller is obligated to deliver the commodity, for which he will be paid the price that was decided in the exchange pit by the brokers. (Sometimes the price can be more or less depending on the grade (quality) of the specific material.) The buyer and seller can eliminate their obligation by offsetting their trade at the exchange before the contract comes due. This is what most speculators do in the commodity markets.
How are the contracts settled?
All the exchanges have both systems—cash and delivery mechanisms. The choice is yours. If you want your contract to be cash settled, you have to indicate at the time of placing the order that you don't intend to deliver the item. If you plan to take or make delivery, you need to have the required warehouse receipts. The option to settle in cash or through delivery can be changed as many times as one wants till the last day of the expiry of the contract.
What you need to know
A right mix of commodities and equity in your portfolio can help you benefit from attractive returns, while reducing the risk component. Go onto the commodities trading exchange—NCDEX and MCX—to see which commodities are offered for trading, their contract size and other criteria. You will have to get hold of a commodities broker to understand how trading works.
Daily financial newspapers carry spot prices and relevant news and articles on most commodities. Besides, there are specialised magazines on agricultural commodities and metals available for subscription. Brokers also provide research and analysis support. But the information easiest to access is from websites. Though many websites are subscription-based, a few also offer information for free. You can surf the web and narrow down you search.