Guide to Commodity Trading | Learn the Basics of Commodity Trading

What is commodity trading?

Why commodity trading is a good diversification method?

Well, to answer all your questions.

I have prepared a go-to guide on commodity trading.

Commodity trading has been around for ages but only a handful of people actually know about it.

What’s the first thing that comes to your mind when you hear the word commodity?

Well, commodities are nothing but the raw materials which are utilized to make finished goods.

The prices of commodities constantly vary based on the change in demand and supply. They fluctuate due to uncertainties that occur and this affects economies all over the world. 

So, in order to make a good commodity trade, I just need to keep in mind certain factors like demand and supply, the seasonality of a commodity, and the right time to execute a commodity trade.

Once you connect all these dots it won’t look so difficult. Commodity trading involves higher risk but it can generate good returns.

You can easily invest in commodities like Gold, Silver, Iron ore, Fossil fuels, and many other commodities that impact the economy and allow investors to gain better options for an increase in profits.

Types of Commodities used for trading

The main types of commodities which are present are, 

• Energy – Some products are crude oil and natural gas.
• Metals – Some commodities under this are aluminium, diamond, nickel, copper, zinc and more.
• Agriculture – Trading is offered in wheat, maize, grains, paddy, pepper, cotton, turmeric and various other commodities.
• Livestock and Meat – Animals are included such as pigs, cattle, chicken and more.

What is Commodity Trading? 

This form of trading is where different assets are bought or sold and this typically happens in commodity futures and options. The future expected value of a commodity is determined and evaluated to make trades. 

Physical trading is not done on the exchange of commodities but an option is available to physically own these assets by choosing the delivery method.

This is a good choice for investors who are interested in diversifying their portfolios.

What are the benefits of Commodity Trading?

• Capital can be protected from inflation by investing in commodities.
• Commodities are traded on online platforms in the present day and this allows a good level of transparency where accessibility is provided to all.
• Losses can be regulated in an investment portfolio by investing in commodities.
• A high level of leverage can be provided.

What are the different ways you can invest in Commodities?

1. Commodities through ETFs

Exchange-traded funds are focused on physical goods which may be natural resources and precious metals. They are traded on exchanges and the risks that come associated with having a futures contract can completely be avoided. The main focus here is on investments that are related to contracts based on the future or on single commodities. 

Pros

• They are inexpensive and affordable.
• The risk of being manipulated decreases and there is a higher level of transparency provided.
• They have lower expense ratios.
• They are much more tax efficient as compared to mutual funds.

Cons

• The intraday pricing may not be beneficial and this may cause problems related to the end investment goal.
• The overall dividend yield is lower.
• Growth prospects may take a hit as there is not much diversification.

2. Commodities through Futures

This is an agreement where a specified amount of commodities are purchased or sold at a price that is before the stipulated date which is yet to come in the future. This is the most common method of commodity trading. This way of trading is safer as the futures are sold on an exchange.

Pros

• The future prices of commodities can be found out and speculated by investors.
• By leveraging margin, money can be saved immediately.
• It is used as a form of assurance against price drops in the future.

Cons

• Risks are involved and the investor can lose the initial margin as well.
• Benefits related to the pricing can be lost if the price decreases to more than what the anticipated rate was.

3. Commodities through Mutual Funds

Similar to ETFs, mutual funds allow trading and investment in commodities without trading with leveraged financial instruments such as futures and options. Indirect exposure to the commodities market is given and returns can be earned on investments. This is suitable for long-term investments and for investors who have a higher tolerance towards big risks.

Pros

• Investors can diversify their portfolios by investing in commodity mutual funds.
• They are managed by fund managers and this ultimately increases the chance of higher returns.
• Good returns are usually offered even if there are fluctuating market trends.
• There are many options provided to help achieve financial objectives.

Cons

• Stocks and commodities have a low correlation with each other and this shows how volatile the supply and demand factors are and this affects the prices.

4. Commodities through Options

This is an option that allows investors to buy or sell underlying commodities at prices that have already been noted on the expiry date in the upcoming future.

The two types of options are the call option and put option.

• The call option allows a trader to buy a commodity at a specific price in the future on a determined date, without any necessary obligation required.
• The put option lets a trader sell the underlying commodity at a specific price on a predetermined date in the future, without being obligated to do so.

Pros

• It provides good leveraging power and is very cost efficient.
• The returns that are gained would be much higher comparatively.
• Options can be utilised to decrease or avoid the chance of risk as it is already defined.

Cons

• It is difficult for traders to enter and exit from the trades.
• The costs incurred are high and it is expensive in comparison with futures.
• The option premium value goes down by a certain percentage every day whether there is movement in the underlying commodity or not.

5. Investing in Physical Commodities directly

This involves trading the actual physical commodities where they are either bought or sold. Investing in commodities can be done as they can be purchased and resold at improved prices to earn profits and gains.

Pros

• A benefit that can be claimed is that the commodities will be available in the form of tangible assets.

• Hacking or any issues which may occur on online platforms wouldn’t be a concern as the commodities are in physical form.

Cons

• The logistics have to be planned and figured out to get the delivery that will be in bulk.
• A huge, free space is required for storing the commodities.
• Insurance plans need to be looked into to avoid any chance of risk due to unpredictable circumstances.
• It is a very costly and time taking process.

How can I start trading in commodities in India?

1. In order to start trading I need to choose a right broker. I will have to open a commodity trading account which will be linked to my bank account.

Chose your broker based on the leverage provided, brokerage charges incurred, annual fees to be paid, and the best, popular trading platforms that are out there.

Some stockbrokers that I highly recommended to start investing in commodities are:

• Zerodha – Either Rs 20 or 0.03%, whichever is lower per transaction.

• Angel Broking – Rs 20 is charged on every executed order.

• Upstox – Based on whichever rate is lower it is Rs 20 or 0.05% for every order that is executed.

2. To open a commodity trading account, ensure that you have the following documents to verify and show the proof of your identity, 

• Your PAN Card
• Aadhaar Card
• A canceled Cheque
• A cheque which shows IFSC or MICR Code
• You will need to have Income Proof as trading in commodity F&O is being done.

3. Submit the documents and enter the details of your demat account. The trading account has to be linked to it. 

In case you don’t have a Demat account, most stockbrokers automatically create one for you at an additional cost during this process.

4. Your application will be processed and an account activation fee will be charged.

5. Time will be taken to process and open your account. The time period that is taken depends on the stock broker.

6. The final step is where you will receive your trading ID and your account will be created. You can start trading when your account gets activated.