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Low Margin High Leverage Commodity Derivatives

18 May 2022 0 COMMENT

Commodity derivatives are high risk and high return financial derivative instruments because of the size of the contracts and nature of the product. In commodity derivatives, the underlying product is the physical commodities like gold, silver, metals, crude oil and agriculture products.  

Commodity derivatives are highly leveraged products and require lower margin than equity futures. The function of leverage signifies risk and reward, i.e. lower margin provides higher leverage and vice versa. It is advised that one should understand the basics of derivatives market, i.e. margin, premium, settlement, leverage, etc.

Just like any other financial market, price in commodity market plays an important role. Here, in commodity market, price movement takes place based on the factors such as supply-demand, macro, and microeconomic factors, government actions, geo-political factors, etc. When traded at an exchange few contracts in commodity derivatives are cash settled and others could be settled by delivery. In case of delivery settlement, an exchange imposes a requirement of additional margin during delivery period. One should be informed about it and carefully watch an open position in such physically settled contracts.

As we have discussed about high risk and high return in commodity derivatives, let us understand this concept with an example, as below. 

Table 1: Equity Derivatives vs. Commodity Derivatives

Particulars

Equity Derivatives

Commodity Derivative

Contract

NIFTY 50

Gold Regular

Margin Requirement

12%

8%

Approximate Price

17200

50000

Contact Size

50 Units

1 KG (1000 Grams)

Value of the contract

8,60,000

50,00,000

Margin required to buy 1 lot

1,03,200

4,00,000

Table 1 highlights comparison between NIFTY50 Futures and Gold 1 Kg Futures. Gold 1 Kg Futures contract size is bigger than Nifty 50 Futures but requires lesser margin. In Nifty 50 Futures leverage is around 12 % where as in GOLD 1 Kg Futures, margin is 8%. Hence in our example, GOLD 1 Kg Futures contract is more leveraged and with a favourable price movement, it should give higher returns.

Let’s see this in the table 2, as below: -

Assuming there is a price movement by   1%. 

Additional Read: Five Commodities to Trade in 2022

Table 2: Impact of leverage

Particulars

Equity Derivatives

Commodity Derivatives

Contract

NIFTY 50

Gold Regular

Margin Requirement*

12%

8%

Approximate Price

17200

50000

Contact Size

50 Units

1 KG (1000 Grams)

Price Movement - 1%

17372

50500

Profit / Loss

(17372 - 17200) X 50 = 8600

(50500 - 50000) X 100 = 50000

*Source: NSE and MCX.

Pl note, margin requirement may vary as per an exchange requirement.

From the above table 2, it is evident that commodity derivatives are highly leveraged products. A 1% price movement in gold leads to a gain of Rs. 50,000 while the NIFTY50 futures leads to lesser gain of Rs 8,600 (lesser by Rs 41,400).

It's important to note that leverage is a double edged sword. While it could increase gains, it could magnify loss in case of an adverse price movement.

Additional Read: All About Commodity Indices

Summary

Commodity derivatives are based on consumable products that are either extracted or cultivated. Commodities are used by all in some form or other. Individuals, manufacturing units, nations, all deal in different forms of commodities. Derivative contracts based on commodities and traded at an exchange provide an excellent means of price hedging and trading. However, it’s important to understand some basic concepts about commodities and derivative trading before entering in this market. Commodity trading at an exchange like MCX is available for five days a week from 9:00 AM to 11:30/ 11:55 PM.

Disclaimer: ICICI Securities Ltd. (I-Sec). Registered office of I-Sec is at ICICI Securities Ltd. - ICICI Venture House, Appasaheb Marathe Marg, Prabhadevi, Mumbai - 400 025, India, Tel No : 022 - 6807 7100. I-Sec is a Member of National Stock Exchange of India Ltd (Member Code :07730), BSE Ltd (Member Code :103) and Member of Multi Commodity Exchange of India Ltd. (Member Code: 56250) and having SEBI registration no. INZ000183631. Name of the Compliance officer (broking): Mr. Anoop Goyal, Contact number: 022-40701000, E-mail address: complianceofficer@icicisecurities.com. Investment in securities market are subject to market risks, read all the related documents carefully before investing. The contents herein above shall not be considered as an invitation or persuasion to trade or invest.  I-Sec and affiliates accept no liabilities for any loss or damage of any kind arising out of any actions taken in reliance thereon. The contents herein above are solely for informational purpose and may not be used or considered as an offer document or solicitation of offer to buy or sell or subscribe for securities or other financial instruments or any other product. Investors should consult their financial advisers whether the product is suitable for them before taking any decision. The contents herein mentioned are solely for informational and educational purpose.