How commodity trading works

Answer these questions.

Do you think gold prices will go up further?

Are you sure that crude oil prices are going to fall?

Have you heard that the soya crop this year is bad and will result in soya prices going up?

If you believe that these predictions have a good chance of coming true and are willing to bet some money on them, you could try your hand at playing the commodity futures market.

In How to trade in Futures, we spoke about stock futures. Here we talk about commodity futures.

The commodity markets have changed a lot from the poky, little hole-in-the-wall trading offices in narrow streets next to crowded markets where traditional dhoti-clad merchants used to trade.

Brand new commodities exchanges---the main ones are NCDEX and MCX---have been set up and these are fully computerised.

More and more stock brokers are setting up commodity brokerages as well, and trading volumes in commodity futures is widely predicted to rival the volume of derivative transactions (futures and options) on the stock exchanges.

What's more, you can also trade online.

 Why commodities trading?

Well, let's suppose you want to buy gold because you believe that the price of gold will rise.

You could then buy gold ingots, store them, wait for them to go up in price, and then sell them at a profit.

But, you have to be sure that the gold you buy is pure, you have to find a place to store it, you have to provide the security, transport it to vault and other such hassles.

A far better way to invest in gold would be to buy gold futures from the commodities exchange.

How do you do that?

When you buy a Gold Futures contract, you undertake to do three things.

1. Buy the amount of gold specified in the contract.

2. Buy it at the price specified in the contract.

3. Buy it on the expiry of the contract. This could be after one month, two months, three months and so on. Of course, if you sell the Gold Futures contract before it expires, then you don't have to worry about actually buying the gold.

Let's say you buy the Gold Future contract at say Rs 7,200 per 10 gm.

Your hunch comes true and the gold prices rally to Rs 8,000 per 10 gm.

You can sell the Gold Futures any time before expiry of the contract.

Gold and other commodity futures prices are quoted on the commodity exchanges in exactly the same way in which stock prices or stock futures prices are quoted on a daily basis in the stock markets.

How it works

Just like stock futures (Read How to trade in Futures to understand how futures work).

When you buy a Futures, you don't have to pay the entire amount, just a fixed percentage of the cost. This is known as the margin.

Let's say you are buying a Gold Futures contract. The minimum contract size for a gold future is 100 gms. 100 gms of gold may be worth Rs 72,000.

The margin for gold set by MCX is 3.5%. So you only end up paying Rs 2,520.

The low margin means that you can buy futures representing a large amount of gold by paying only a fraction of the price.

So you bought the Gold Futures contract when it was Rs 72,000 per 100 gms.

The next day, the price of gold rose to Rs 73,000 per 100 gms.
Rs 1,000 (Rs 73,000 – Rs 72,000) will be credited to your account.

The following day, the price dips to Rs 72,500.
Rs 500 will get debited from your account (Rs 73,000 - Rs 72,500).

What you need to know

Compared to stocks, trading in commodities is much cheaper, because margins are much lower than in stock futures.  

Brokerage is low for commodity futures. It ranges from 0.05% to 0.12%.

Because of this, commodity futures are a speculator's paradise.

If you are a hard-core trader who follows the technical charts and do not really care what you trade, and if you are nimble and savvy, then commodity futures could be another asset class that you would be interested in.

The advantages in this line is that there are no balance sheets, no complicated financial statements----all you have to do is follow the supply and demand position of the commodities you trade in very closely.

Go onto the commodities trading exchange - NCDEX and MCX - to see which commodities are offered for trading, their contract size and other criteria. You will have to get hold of a commodities broker but that should not be a problem. There are lots of brokers that offer commodity trading these days.

But, it would be wise to avoid commodity trading if you are a rookie. A better move would be to initially trade in stock futures before opting for commodity futures.