How Commodity Market Works in India?

Whenever we hear the word ‘trading’, what comes to our minds immediately is the stock market. Investors acquire and trade in company stocks on stock exchanges. As an investor you can trade in the commodity market as well which involves buying and selling commodities.

Trading in commodities

There are four broad categories of commodities in which you can trade, just the way you trade in stocks.

• Metals: gold, silver, copper etc.
• Energy: crude oil, gasoline etc.
• Agricultural produce: wheat, rice etc.
• Livestock & meat products: eggs, for example

There exist two different categories of trading -- spot and derivative.

Spot Trading:

The commodity in the spot market is transacted with the intention of physical delivery taking place immediately or within a few days. These transactions are typically settled within a timeframe of two days, and, therefore, more exposed to price fluctuations.

Derivative Trading (Futures & Options):

With respect to derivative trading in commodities, the transactions take place by way of contracts such as futures and options. Herein, the 'derivative' is referred to the underlying commodity on whose price movements the trading will take place as per the specific contract. On maturity of the contract, you have the option to either take the physical delivery of the commodity or settle it in cash, depending on the specifics of the contract.

Types of contracts:

There are two types of commodity contracts in the commodity market in India. These are explained below:

• Future contract:

  Under this type of contract, a certain amount of the underlying commodity, crude oil for example, is decided to be transacted between the buying and selling parties at a pre-decided rate. Considering the date of maturity of this contract is at a future pre-decided day, only a margin of the whole price of the commodity, is required to be paid by the buyer when the future contract is bought. Typically, producers of commodities undertake these contracts to safeguard themselves against fluctuating prices. While investors buy these contracts to hold a diversified portfolio which includes varying instruments.

• Options contract:

  Options contracts differ from futures contracts, because both the parties in the former type of contract decide that they do not want to take the physical possession of the underlying commodity. Options can be defined as contracts that give a buyer the right to buy or sell the underlying asset, or the security on which a derivative contract is based, by a set expiration date at a specific price. This specific price is often referred to as the "strike price." It's the amount at which a derivative contract can be bought or sold. Option contracts work by way of call and put contracts. A call option is bought if the trader expects the price of the underlying to rise within a certain time frame. A put option is bought if the trader expects the price of the underlying to fall within a certain time frame.

Workings of Commodities Market

An important point to remember is that in the commodities market an upward price trend benefits the buyer whereas a downtrend benefits the seller. Considering both futures and options contracts lock in the price at which the trading of a particular commodity will take place, the price movement is the only matrix which would define profit or losses for the parties.

For example, if you are trading on gold for Rs 50,000 for 100 gm, and the price increases to Rs 52,000 the next day, as a buyer of the contract you will benefit as the purchase of gold through this contract will render you with a profit of Rs 2,000 on 100 gm. However, as a seller of this contract, you will suffer a loss and not be able to take advantage of the higher market price because of the contract strike price of Rs 50,000.

Conclusion

While the commodity market is an efficient avenue to invest in for diversification of your portfolio, it is commonly undertaken by speculators who wish to earn short-term profits and exit. To fully understand how the commodity market works, you will require experience and close monitoring of the commodity prices. Making money through the commodity market needs expertise in the commodity you trade. It is highly advised that before venturing into this sector, you gain sufficient knowledge from an expert about the commodity you wish to trade in and monitor its price movements.

URLs Used for Research

What is Commodity Trading - Definition, Advantages & History (samco.in)

Commodity Options : All About Commodity Options | Angel Broking