The investing options in India have evolved over the years. The introduction of commodity futures trading has enabled investors to diversify their portfolios, manage risk, and profit from speculating on commodity prices. Let's understand commodity future benefits and explore investing in futures of commodities.
The commodity future is a derivative contract where investors agree to buy or sell a fixed amount of commodity at a predetermined price on a predetermined date. You can invest in different commodities like food, energy, and metals.
Futures contract pricing depends on the spot price of the underlying commodity. Other factors like interest rates, time until delivery, and storage costs also influence its price.
Buyers of commodity futures make profits when the value of the underlying commodity increases at the expiration of the futures contract. On the other end of the contract, the seller will make a gross profit when the price of the underlying commodity decreases at expiration.
With a futures contract, investors need not pay the full cash upfront to control the underlying asset. You only need to deposit a small margin. The margin is determined as a percentage of the contract value.
The value of the commodity futures contract (notional value) is determined by multiplying the price of the underlying commodity and the contract size. The contract size is the deliverable number of underlying commodity units for each commodity. Essentially, a single futures contract can represent multiple units of a commodity.
Commodity trading is highly leveraged because you only deposit a percentage of the contract value. Thus, even a tiny change in the price movement can significantly impact your profit or loss. With higher margin requirements, you must deposit more to enter the future position, lowering the leverage.
The tick size of the futures contract is the minimum price increment for a specific contract fluctuation. The tick size is set by the exchange based on the contract specifications. According to the contract specification, the monetary amount will be gained or lost per tick move. To calculate the tick value, multiply the tick size by the contract size.
The commodity futures are settled daily in the futures commodity market. When the trading day ends, the exchange where the futures are traded determines the closing market price. This is called the daily mark-to-market (MTM) price. The MTM price remains the same for all, and settlements occur at the contract's expiry or when the position is closed out.
The daily cash settlement is the difference between the close price of t-1 and t. The contract holder's account will be debited or credited based on the result. When the contract value increases during daily settlement, the long position holder's account will be credited and the short position holder's account will be debited.
Traders have the obligation to act based on future contracts. Unless you unwind the futures contract before expiration, you must buy or sell the underlying asset at the specified price.
Commodity futures are closed out or netted at the date of expiration. Cash settled refers to the difference between the original and closing trade prices. You can use commodity futures contracts to take positions on assets such as
The commodity futures contracts are named after the expiration month. For example, futures contracts ending in October are called October futures contracts.
Speculators use commodities futures contracts for directional price bets based on the underlying asset's price. You can take this position in either direction. Some investors go long (buy) or go short (sell). Due to the high leverage, you need not put down the total contract amount to take this position. Instead, you must deposit the margin (a fraction of the trading amount) with your futures brokerage account. Different brokers offer varying leverage for the commodities.
For instance, to enter a futures contract for 100 barrels of crude oil valued at Rs 4,500 per barrel (total contract value of Rs 450,000) on the MCX, a trader typically needs to deposit an initial margin of around Rs 37,000.
If the oil price rises to Rs 6,000 per barrel at contract expiry, the trader would realise a profit of Rs 150,000. This profit (or loss) would be settled in cash through the trader's brokerage account.
Most futures contracts traded on Indian exchanges are cash-settled, avoiding the complexities of physical delivery.
Some of the benefits of commodity futures trading are:
While industrial units largely favour commodity trading, individuals can also enter the market using online brokerage accounts. Different commodities, such as MCX, can be traded depending on the exchange. The different lot sizes allow participants to take positions on different commodities based on their affordability. As global factors determine pricing, the commodities market is more transparent. Here is how you can start investing in commodity futures:
Futures and commodity trading contracts enforce an obligation to purchase or sell the underlying assets. Failure to close the existing position at the right time can result in the accepting delivery of unwanted commodities. Inexperienced investors may not be ready to deal with amplified gains and losses in futures contract positions. Learning future contract strategies is crucial to benefiting from the derivatives market.