How Does Commodity Market Work?

The stock market often takes centre stage in discussions about trading, but it is far from the only financial market available. Equally significant is the commodities market, a thriving sector where physical goods such as precious metals, energy resources and agricultural products are actively traded. 

With the nominal value of the commodities market projected to reach $855.60 billion by 2025, it is clear that this market plays a crucial role in global finance.

In this blog, we will explore how does the commodity market works, examining its marketplace, key benefits, potential limitations and the various types of commodity contracts traders can engage with. 

What are Commodity Market Instruments?

Commodity market instruments are financial tools designed to facilitate the trading and exchange of physical goods, particularly in markets where supply may be limited or volatile. These instruments allow investors, companies and other entities to trade commodities with dual objectives: earning monetary gains and mitigating risks associated with market fluctuations.

Two of the most common commodity market instruments are futures contracts and options contracts, each offering distinct mechanisms for trading and risk management. Let us explore these in detail to understand how does the commodity market works:

• Futures Contracts

A futures contract obligates parties to trade a specific quantity of a commodity at a predetermined price on a future date. There are two types of futures contracts, exchange-traded futures and over-the-counter futures. 

Exchange-traded futures are standardised and regulated by exchanges for transparency and risk reduction. Whereas, for over-the-counter (OTC) futures, you can privately negotiate with greater flexibility but higher risks.

The participants of futures contracts are producers, who hedge against price volatility and speculators, who profit from market fluctuations.

• Options Contracts

Under SEBI regulations in 2017, options trading in top commodities allowed investors to acquire the right, but not an obligation, to buy or sell a commodity derivative at a predetermined price. It offers reduced risk with no mandatory trade execution and the potential to profit from market movements.

Understanding Commodity Markets and How Does it Work

The commodity market operates primarily under the law of demand and supply, with market equilibrium achieved when demand matches supply. Trading in the commodity market follows a systematic process divided into four key stages, each representing a critical phase in the journey of a commodity.

Follow these stages to understand how does the commodity market works:

• Stage 1: Primary Production

The process begins with the production of raw commodities. This stage, known as primary production, involves activities such as farming, animal husbandry and mining. Primary producers like cultivators, livestock rearers and miners, harvest or extract these resources and bring them to the market for sale.

• Stage 2: Secondary Production

In this stage, you can transform raw materials into finished products. For example, workers spin cotton into yarn or weave it into cloth, mill wheat into flour, and process rice into rice powder. This phase, referred to as secondary production, adds value to raw commodities and prepares them for broader commercial use.

• Stage 3: Distribution Trade

The third stage involves the sale and distribution of finished goods. Traders, wholesalers and retailers play a vital role in connecting producers with consumers by making these goods accessible in the market. This stage ensures the efficient movement of commodities from production hubs to retail points where they are available for purchase.

• Stage 4: Consumption

The final stage is consumption, where individuals, businesses or institutions use these goods either to fulfil their needs or as inputs for further processing or production. At this point, the commodity's lifecycle in the market concludes, having served its purpose.

Also Read : Commodity Channel Index (CCI) - Uses, Calculation & Example

How Commodity Trading Works?

Commodity trading facilitates the exchange of physical goods such as metals, agricultural products and energy resources. It operates through structured platforms and mechanisms, offering investment opportunities while managing market risks. Here is a detailed breakdown:

1. Choose a Broker: Select between brokers that offer full-service or discount options.
2. Open Accounts: Create a demat and trading account with required documents (PAN, Aadhaar, income proof).
3. Deposit Funds: Add an initial deposit, typically 10% of the contract value and maintain margin requirements.
4. Market Access: Trade commodities through exchanges, brokers or online platforms.

Types of Commodities

By facilitating the exchange of tangible goods like oil, gold, and coffee, commodity market instruments leverage the intrinsic and extrinsic value of these assets to create opportunities for profit and risk management. 

To succeed in this market, it is crucial to understand the commodity trading basics and the diverse categories of commodities available for trade. Below, we explore the primary types of commodities:

• Agricultural Commodities

This category encompasses crops and products derived from farming and agriculture, such as chana (chickpeas), soybean, jeera (cumin), rice, and rubber. These commodities are highly sensitive to factors such as weather conditions, global demand-supply dynamics and government policies.

• Metals

There are further two subcategories of metals, such as industrial metals and precious metals. Industrial metals include essential materials like aluminium, copper and lead, which are critical for manufacturing and construction industries. Precious metals, including pricy metals like gold and silver, hold significant value for both industrial applications and investment assets, often serving as a hedge against inflation.

• Energy Commodities

Energy commodities consist of resources that fuel various aspects of modern life, such as natural gas, crude oil and coal. Geopolitical events, supply-demand dynamics, technological advancements and shifts in global economic conditions influence the prices of these commodities.

The Bottom Line

Commodity prices are shaped by a variety of factors, making thorough research and a solid grasp of market dynamics crucial for successful trading. A deep understanding of how does the commodity market work is particularly essential in crafting effective trading strategies.

It is also important to note that the use of leverage in commodity trading can amplify both profits and risks. Beginners are encouraged to consult market experts, stay informed through reliable research, and closely monitor market trends to navigate these challenges effectively.

Equipped with a strong foundation in the types of commodities, trading methods and price movement patterns, you will be well-prepared to embark on a confident and informed commodity trading journey.