Basics of Trading in Commodities

There is a surging interest among investors in commodities, which as an asset class can provide opportunities to fine-tune a portfolio’s risk and return characteristics. The commodities asset class has experienced strong growth in recent years. The low historical correlation to financial assets, equity-like returns and risk characteristics of commodities provide investors a means to diversify their portfolios.

Commodities and futures: Commodities include goods used in the initial phase of the manufacturing process and are real assets such as energy, industrial and precious metals, agriculture, and livestock. Meanwhile, futures are contracts of commodities that are traded at a futures exchange.
However, futures contracts have expanded beyond just commodities and transactions now include futures contracts on financial markets, currencies and many others.

Commodities futures contract: This is a standardized contract set by a particular futures exchange that includes the size in barrels, bushels or tonnes, the place for deliveries, the type and quality of the commodity to be delivered as well as the transaction price. The futures contract is negotiated on a regulated futures exchange where all buy and sell orders are routed to a single location on the exchange.

Commodities trading: Brokers who are members of that exchange engage in transactions on whatever commodity is being traded on. Both seller and buyer have their respective brokers for transacting an order for a purchase and sale. Further, both buyer and seller enter into obligations.

The former is obliged to take delivery and pay for the commodity in cash within a specific timeframe, while the seller is obliged to deliver the commodity for the price that had been ascertained when the contract was signed. The buyer and seller can also absolve themselves of the obligation by offsetting their trade before the contract expires.

Commodities trading in India: A capital as low as Rs 5,000 is enough to begin trading. The money goes to margins payable upfront to exchanges through brokers. The margins range from 5-10% of the value of the commodity contract. The exchanges are regulated by the Forward Markets Commission and unlike the equity markets, brokers need not register with the regulator.

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