5 reasons to trade in commodities
Commodity trading has been gaining traction amongst the Indian investors' fraternity after the merger of commodity market regulator i.e., Forward Markets Commission (FMC) with the Securities and Exchange Board of India (SEBI) on 28 September 2015. After the merger, the regulator took a series of measures to strengthen the commodity market ecosystem. After the unification of exchanges and trading members, the investors and traders are allowed to trade in all asset classes such as equities, commodities, and currencies with a single Unique Client Code, single bank account, and transfer of funds between different asset classes. Considering all these positive factors, here are the 5 reasons to trade in commodities.
Trading in commodities create a best portfolio diversification as the commodity prices move independent of other asset classes. In an economic turbulence, when the stocks, currency, and bond market falls, gold is considered as safe haven buying tool. At the same time, the demand for metals and energy products diminishes owing to poor economic performance. Diversification of your portfolios among several asset classes such as equities, commodities, currencies, and bonds protect you against the unanticipated market movement in one or more asset classes because they are independent of one another.
Commodities have historically confirmed an inverse relationship with other asset groups. When global economic growth improves, demand for riskier assets like bonds and currencies rises, while demand for safe-haven assets like gold falls, and vice versa. The safe-haven investment, gold, has historically reacted negatively to increases in the dollar and bond yields. During times of economic turmoil, gold appeals as a safe haven investment, while demand for metals and energy falls, and vice versa. For example, in 2020, when the global equities market, currencies, and bond markets were under pressure due to the global outbreak of COVID-19, demand for energy and metals was also down, resulting in a drop in prices to multi-year lows, while gold—a safe-haven metal—soared to an all-time high. Crude oil prices even fell into the negative territory for the first time in commodities trading history.
The following tables give proof of inverse correlation between different asset classes such as commodities, equities, currencies, and bonds.
In the global market, commodities are carrying a negative correction with dollar index and 10-year U.S. bond yields while their relation with equities is slightly positive still it is considered as an inverse correlation. The equity indices carry a strong positive correlation with crude oil and base metals because of growth in the global economic condition creates an additional demand for energy and metals across the sectors.
A similar trend can be seen in the Indian market also wherein the equity indices—NIFTY and SENSEX—are having a near-zero correlation with gold while a strong correlation with crude oil and base metals. Considering all the above-mentioned factors, commodities are a must asset class to build a strong and profitable portfolio. To start trade in commodities, open demat account with ICICI Direct
Hedge against inflation
Inflation is one of the key factors in the growth of the global economic condition. A sharp rise in prices of goods leads to higher inflation thereby reducing the purchasing power of the common citizens. To control higher inflation, governments and central banks keep on taking appropriate measures as and when needed. In such a situation, gold is considered as a hedge against inflation. When inflation rises or interest rates are extremely low, gold has traditionally been a safe-haven asset for investors. When real interest rates go below zero, gold tends to do well. During difficult economic times, investors often look to gold as a store of value, and it has served this purpose for a long time.
Increasing demand for commodities
With an expansion of the world in terms of industries and population, the demand for commodities has been increasing multifold while the supply is not up to the mark to meet the growing demand. Since the outbreak of pandemic coronavirus in March 2020, there was an acute shortage of various commodities especially metals because of closure of mines and smelters along with labor strikes. Projection of global economic condition by World Bank as well as Internatonal Monetary Fund is also creating an additional demand for the metals. Further, new commodity backed Exchange Traded Funds are being launched, which is also creating an additional demand for the commodities. Crude oil consumption has been increasing tremendously as the vehicle production and sales are increasing across the globe.
The commodity derivatives gives a greater leverage for the investors to take both buy and sell positions buy paying a small amount in the form of an initial margin. By paying 10% of the total contract value, the investors get a leverage of holding the commodity of greater value. For example, the price of gold is at Rs. 48,000 per 10 grams and if you want to buy 1 kilo of gold from the spot market, you have to pay Rs. 48,00,000 upfront to the sellers. When you are taking a position in the futures market, instead of paying full amount, you will be paying 10% of total value of the product i.e., Rs. 4,80,000 and holding the buy position worth of Rs. 48,00,000.
Higher liquidity and returns
Futures markets are more liquid than other markets because they meet the following criteria.
- Commodities are having an active spot or cash market, which is considered as basis for futures trading.
- Many buyers and sellers consisting of traders/investors, hedgers and arbitrageurs.
- An open, transparent and and strong delivery mechanism.
- The derivative and the physical commodity have a well-defined relationship.
- Convergence of cash and futures prices at the expiry of the futures contract making the system more robust for all participants.
Also Read: How to trade in commodity?
Daily trading volumes and open interest, as well as the number of open long and short positions, can be used to determine the liquidity of specific futures products. The commodities available for trading on Indian exchange are clocking a descent volume and turnover everyday making the segment of the favorite asset class among the investors.
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