Basics of Commodities Market

If you thought that the equity market was the only financial market in the world, then you’re in for a surprise. As a matter of fact, there are a couple of other financial markets that are as popular as the stock market - the currency market and the commodities market. Let’s delve a little deeper into the specifics of the commodities market and try to understand the basics.

What is the commodities market?

Similar to how the shares of a company are traded in the stock market, commodities are bought and sold in the commodities market. This financial market is widely utilized by producers, manufacturers, and wholesale traders as a price discovery mechanism for the various goods and commodities.

Just like with the stock market, there are dedicated commodity exchanges that enable the market participants to easily buy and sell commodities online. In fact, there are three primary commodity exchanges that are currently operational in India - the Multi Commodity Exchange (MCX), National Commodity and Derivatives Exchange (NCDEX), and Indian Commodity Exchange (ICEX).

What are the different commodities that are traded?

Most traders and investors simply classify the different commodities that are traded into agricultural and non-agricultural commodities. The non-agricultural commodities can be further sub-classified into three different categories - bullion, energy, and base metals. Here’s a brief list of the different types of commodities under each category that are regularly bought and sold in the exchanges.

• Bullion - Gold and silver
• Energy - Crude oil and natural gas
• Agriculture - Black pepper, cardamom, castor seed, cotton, palm oil, kapas, wheat, paddy, chana, bajra, barley, and sugar, among others
• Base Metals - Aluminium, copper, lead, nickel, and zinc

How do you invest in commodities?

Firstly, to invest in commodities, you would need to open a trading account with a brokerage firm of your choice. And since commodities are physical goods and not electronically held securities, you only require a trading account and not a demat account. That said, there are two ways using which you can invest in the commodities of your choice - through a futures contract or through an options contract.

Both futures and options are known as derivatives. They derive their value from the underlying asset, which in this case would be the commodity. When you purchase or sell a derivative contract, you essentially enter into an agreement to either buy or sell the underlying asset at a predetermined price and quantity at a specific time in the future.

Let’s take up an example to better understand the concept of investment in commodities. Assume that you’re interested in investing in gold. In order to do so, you can either purchase a gold futures contract or a gold options contract through your trading account. Let’s say that you purchase a futures contract for around Rs. 52,000 for 10 grams of gold. The contract expires one-month from today.

By entering into this contract, you’ve essentially agreed to buy 10 grams of gold for Rs. 52,000 on a future date that’s one-month from today. Now, assume that you hold onto the contract till its expiry. Upon expiry of the contract, the seller, who sold the 10 grams of gold for Rs. 52,000 to you, would now be obligated to physically deliver the specified quantity to you.

While getting the commodities delivered to you physically is one way to invest in them, you could also make use of the short-term price movements to your advantage as well. You could invest by buying either futures or options of your favourite commodities, hold onto them for a while, and then trade them off before the contract expiry to make some investment gains.

Conclusion

As with most online investments, your journey into the commodities market starts with the need to open a trading account with a brokerage firm. Once you have your own trading account set up and ready, you can start investing in the various commodities of your choice through derivative contracts such as futures and options.

Here’s a word of caution. When you purchase commodity derivative contracts and hold them till expiry, the contracts are mandatorily settled through physical delivery. Therefore, if you don’t wish to take delivery of the commodities that you’ve invested in, ensure that you close all your open positions well ahead of the contract expiry.