Basics of Commodities Market If you thought that the equity market was the only financial market in the worid, then you're in for a surprise. There ate a couple of other financial matkets that are as popular as the stock market vir the currency market and the commodities market. Let's delve a litle 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 various goods and commodities. Just like the stock market, there are dedicated commodity exchanges that enable the market participants ‘to easily buy and sell commodities online. Three primary commodity exchanges are currently operational in india - the Multi Commodity Exchange (MCX), National Commodity and Derivatives Exchange (NCDEX), and indian Commodity Exchange (ICEN). What are the different commodities that are traded? Most traders and investors simply classity the different commodities into agricultural and non-agricutturat commodities, The non-agricultural commodities can be further sub-classined into three different categories - bullion, energy, and base metals. Here's a bref list of the different types of commocities under eaci category that is 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, apas, wheat, paddy, chana, bajra, barley, and sugar, among others © Base Metals - Aluminum, 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 the brokerage firm of your choice. Since commodities are physical goods and not electronically held securities, you only reauire a ‘trading account and not a Demat account. There are two ways in which you can invest in the commodities of your choice - through a futures contract or 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 agree 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. To do so, you can either purchase @ 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 after a month from today. y entering into this contract, you've essentially agreed to buy 10 grams of gold for Rs. 52,000 on a future dite 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 expires 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 trading account set up and ready, you can start esting in the various commodities of your choice through derivative contracts such as futures and options. When you purchase commodity derivative contracts and hold them tll 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.What are the Commodity Exchanges available in India? India has 22 commodity exchanges that have been set up under the Forward Markets Commission. The following commodity exchanges are popular choices for trading in India~ 1, Multi Commodity Exchange of India (MCX) 2. Indian Commodity Exchange (ICEX) 3, National Multi Commodity Exchange of India (NMCE) 4, National Commodity and Derivative Exchange (NCDEX) What is a Commodity Futures Contract? The ‘commodity futures contract’is the assurance that a trader will buy or sell a certain amount of their commodity at a pre decided rate at a certain time. When a trader purchases a futures contract, they are not required to pay the whole price of the commodity. Instead, they can pay a margin of the cost which is a predetermined percentage of the original market price. Lower margins mean one can buy a futures contract for a large amount of a precious metal like gold by spending only a fraction of the original cost. Speculators: These dealers constantly examine the costs of commodities in addition to forecasting the expected price changes. For instance, fa speculator predicts that the price of gold was to increase, they purchase the commodity futures contract. If the cost of gold subsequently grows, the trader will then sell the contract for a higher price than they bought. If the speculator anticipates that the rate of gold will decrease, they sell their futures contract. Once the prices lower, speculators buy the contract again for a lower price than what they sold it for. This is how speculators make profits in both cases of market change. Hedgers: Those who produce or manufacture commodities typically ‘hedge their risk’ by trading in a commodity futures market. For instance, if the prices of wheat fall during the harvest period, the farmer ll face a loss. The farmer can hedge this risk by entering a futures contract. In this case, when the price of his produce falls in his local market, the farmer can offset this loss by making, profits through the futures market The opposite situation is when the cost of wheat increases during the harvest period. AC this time, the farmer would encounter losses in the futures market. However, these losses can be ‘compensated for by selling his produce for a higher cost in his local market.What Is a Commodity Index? Acommodity index is an investment vehicle that tracks the price and the return on investment of a basket of commodities. These indexes are often traded on exchanges. Many investors who want access to the commodities market without entering the futures market decide to invest in commodities indexes. The value of these indexes fluctuates based on their underlying commodities; similar to stock index futures, this value can be traded on an exchange. KEY TAKEAWAYS « Acommodity index is an investment vehicle that tracks the price and the return on investment of a basket of commodities. « The value of these indexes fluctuates based on their underlying commodities. + Commodity indexes vary in the way they are weighted and thecommodities that they are comprised of. * Commodity indexes differ from other indexes in one very important way: the total return of the commodity index is entirely dependent on the capital gains, or price performance, of the commodities in the index. How a Commodity Index Works Every commodity index on the market has a different makeup in terms of what goods itis comprised of, The Thomson Reuters/CoreCommodity CRB Index is traded on the New York Board of Trade (NYBOT). This index consists of 28 different types of commodities, including barley, cocoa, soybeans, zinc, and wheat. Commodity indexes also vary in the way they are weighted: some indexes are equally weighted, which means that each commodity makes up the same percentage of the index. Other indexes have a predetermined, fixed weighting scheme that may invest a higher percentage in a specific commodity. For example, some commodity indexes are heavily weighted for energy-related commodities like coal and oil. The Dow Jones futures index was the first index to track commodity prices in 1933, 41 Goldman Sachs launched its commodity index in 1991, called the Goldman Sachs Commodity Index (GSCI). Goldman Sachs's index was renamed the S&P GSCI when it was purchased by Standard and Poor's in 2007. 21°! The Bloomberg Commodity Index (BCOM) family and the Rogers International Commodity Index (RICI) are two other popular commodity indexes.What Is a Commodity Futures Contract? Acommodity futures contract is an agreement to buy or sell a predetermined amount of a commodity ata specific price on a specific date in the future. Commodity futures can be used to hedge or protect an investment position or to bet on the directional move of the underlying asset. Many investors confuse futures contracts with options contracts. With futures contracts, the holder has an obligation to act. Unless the holder unwinds the futures contract before expiration, they must either buy or sell the underlying asset at the stated price. Commodity futures can be contrasted with the spot commodities market. KEY TAKEAWAYS, * Acommodity futures contractis a standardized contract that obliges the buyer to purchase some underlying commodity (or the seller to sellit) at a predetermined future price and date. * Commodity futures can be used to hedge or protect a position in commodities. * Afutures contract also allows one to speculate on the direction of a commodity, taking either a long or short position, using leverage. © The high degree of leverage used with commodity futures can amplify gains, as well as losses.* Crudeoil Wheat * Corn * Gold * Silver * Natural gas Commodity futures contracts are called by the name of their expiration month, meaning a contract ending in September is a September futures contract. Some commodities can have a significant amount of price volatility or price fluctuations. As a result, there's the potential for large gains but large losses as well. F Important: Commodity futures and commodity forward contracts are functionally similar. The major difference is that futures are traded on regulated exchanges and have standardized contract terms. Forwards instead trade over-the-counter (OTC) and have customizable terms.Hedging with Commodity Futures Contracts Another reason to enter the futures market is to hedge the price ofa commodity. Businesses use futures to lock in prices of the commodities they sell or use in production. The goal of hedging is to prevent losses from potentially unfavorable price changes rather than to speculate. Many companies that hedge use or produce the underlying asset of a futures contract. Examples include farmers, oil producers, livestock breeders, and manufacturers. For example, a plastics producer could use commodity futures to lock ina price for buying natural gas by-products needed for production ata date in the future. The price of natural gas—like all petroleum products—can fluctuate considerably, leaving an unhedged plastics producer at risk of cost increases in the future. Ifacompany locks in the price and the price increases, the manufacturer would have a profit on the commodity hedge. The profit from the contract would offset the increased cost of purchasing the product. Alternatively, the company could take delivery of the product at a cheaper fixed price.Introduction to Commodity Options “Options. as the word suggests, refer to choices or alternatives. An option is a derivative contract which gives the buyer (the owner or holder of the option) the right, but not the obligation, to buy or sellan underlying. For owning this right, the option holder pays a price (called ‘option premium) to the seller of this right The seller (writen of option, on the other hand, bears the obligation to honour the contract should the buyer choose to exercise the option, ‘The option buyer will exercise their option only when the price of the underlying is favourable to them, otherwise they will let the option expire worthless. Based on the right of the holder. options are of two types * Call options: It gives buyer the right to buy the underlying * Put options it gives buyer the right to sell the under'ying Based on exercise, options can primarily be of two types: « American: The buyer can choose to exercise the option at any time before the expiry of the option contract. + European: The buyer can choose to exercise the option only on the date of expiration of the contract. As per current regulatory norms, only European style commodity options are available in India at present. MCX offers options on commodity futures contracts traded on the exchange. These commodity options, on exercise, devolve into the underlying futures contracts. All such devolved futures postions open at the strike price of exercised options. Commodity options are useful risk management tools, particularly for the small stakeholders, as the option buyer does not generally have to maintain margins. They are akin to price insurance for the hedgers which can be bought by paying only a one-time option premium.What Is the Difference Between Hedging, Speculation, and Arbitrage? Hedging, speculation, and arbitrage all are fairly sophisticated, and usually short-term, investment strategies. Speculation is a trading strategy that often involves very quick-paced buying and selling. It's based on hunches, educated guesses, or theories on price moves—as opposed to fundamentals—about the financial asset or investment. Assuch, the timing of entry and exitis crucial. Designed to achieve fast profits, speculation involves a significant amount of risk. Hedging is investing with the intention of reducing the risk of adverse price movements in an asset. A hedge consists of taking an offsetting or opposite position in a security that is the same as, or related to, the one the investor already has. It's a defensive move, designed to limit loss.Arbitrage is a form of hedging. It also involves making seemingly contradictory investment moves—specifically the simultaneous buying and selling of an asset (or equivalent assets), often in different markets or exchanges, in order to profit from small variations in price. Primarily used by large, institutional investors and hedge funds, arbitrage involves low risk, if executed carefully and precisely. What Is the Difference Between Hedging and Derivatives? Hedging and derivatives are actually two different animals. Hedging is an investment technique or strategy. Derivatives are investment instruments—a type of asset class. The two are related, though, in that hedging strategies—which aim to insure against overall loss—often use certain kinds of derivatives, especially options and futures contracts.