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What is a Commodity Market?
Commodity market facilitates an exchange of physical goods among residents in a country. Individuals aiming to diversify their portfolio can undertake investments in both perishable and non-perishable products, thereby not only mitigating the risk factor, but also providing a hedge against inflation rates in an economy.
Types of Commodities in the market , available for trading are categorised into the following classes, based on their inherent nature –
- Hard commodities –
- Precious metals – Gold, platinum, copper, silver, etc.
- Energy – Crude oil, Natural gas, gasoline, etc.
- Soft commodities –
- Agriculture – Soybeans, wheat, rice, coffee, corn, salt, etc.
- Livestock and meat – Live cattle, pork, feeder cattle, etc.
As of 2019, some examples of commodities in the market that were most commonly traded in major commodity exchanges in India included crude oil and silver. While crude oil acts as one of the most important energy sources required for virtually every industry, silver is one of the most precious metals other than gold with a steady demand.
As crude oil is not domestically available in abundance, almost 82% of it is imported from OPEC and Middle Eastern countries. Similarly, silver is traded in extensive quantities from countries such as Mexico, Peru, etc.
How to Invest in the Commodity Market?
Commodity trading is managed by four major commodity exchanges in India –
- Multi Commodity Exchange (MCX)
- Indian Commodity Exchange (ICEX)
- National Commodity and Derivatives Exchange (NCDEX)
- National Multi Commodity Exchange (NMCE)
All activities of such nationwide exchanges come under the regulation of Commodity Derivatives Market Regulation (CDMRD) of Securities and Exchange Board of India, which merged with Forward Market Commission in 2015.
Commodity markets facilitate an exchange of both physical goods and derivative contracts while the physical exchange is undertaken by institutional investors and commodity brokers aiming to realise gains through the resale of the products in the retail sector of the country.
Conversely, a derivative contract does not require a physical store of the goods procured, as individuals can trade commodities online through digitised contracts, making the transaction hassle-free and convenient.
Investors can practice investing in commodity markets through a futures or options contract. While a futures contract dictates individuals to sign a deed stipulating delivery of a product at a later date with respect to a fixed price, an options contract acts as an agreement but not a liability of the same.
Future derivative trading is most common in the commodity market, wherein sellers sign a futures agreement with brokers/buyers to purchase a stipulated quantity of products at a given price. While a downtrend in the market prices can help sellers realise margin profits, a rising price can help buyers or brokers profit from the transactions.
If such trade is supervised by commodity exchange, it is known as a future derivative contract. Any settlement between two parties without any overseeing exchange is known as over the counter exchange trading.
Both exchange-traded and derivative future contracts are undertaken by two primary classes of investors – producers aiming to reduce fluctuations in final good price, and speculators aiming to profit from the volatility of a futures contract.
As of 2017 SEBI regulations, options trading can be practised while investing in top commodities wherein traders enjoy a right but not obligation to purchase/ sell a commodity derivative at a fixed price. Partaking in commodity investment through such agreements help individuals profit from any market fluctuations, as no obligation regarding the purchase or sale of products is imposed on either of the parties, depending upon the type of options contract.
Relationship of the Commodity Market and Stock/Bond Market
One of the features of a commodity market is that its performance demonstrates an inverse relation with both stock and bond markets, as the bond and stock prices fall when the average price level of goods rise in the economy.
During times of rising aggregate price level or inflation, the prices of commodities traded on respective exchange rises significantly. As extreme inflation has a negative impact on consumers, the government often tries to tackle the situation by increasing the domestic lending rates through a repo rate hike. As the cost of borrowing rises, investors often reduce their speculative demand for stock market investments, making the prices of capital sector plummet.
The bond market is also affected as a result of such a hike in the lending rates levied by scheduled commercial banks, as interests on respective savings tools rise. Consequently, fixed coupon bonds indicate a relatively less profitable investment venture, thereby creating a surplus amount of bonds with reduced demand, causing bond prices to fall.
While bond and stock prices move in the opposite direction as compared to commodity prices, investment in commodities, especially in precious metals and energy sources, tend to generate significant returns for investors.
Traders in a Commodity Market
The commodity markets holds importance for two kinds of individuals based on the commodity market operations they partake in :-
Such investors aim to reduce exposure to market volatility by entering into a futures contract with traders. Any change in the price level does not affect the rate at which respective commodities are traded in the market. Most hedgers trade physical goods in the commodities market, as they require the stipulated goods or production or resale purposes.
Investors aiming to generate substantial profits from trade in the commodity market are termed as speculators. A prediction regarding the direction of movement of market prices are assumed by such individuals before signing a futures contract, and depending upon accuracy of market forecast, positive or negative returns can be realised, subject to spot prices.
Speculators don’t desire physical possession of the goods traded, and hence, opt for a cash settlement to reduce the hassles of physical trading.
How are Prices Determined in Commodities Exchange?
The prices of commodity markets are heavily dependent on the market demand and supply of commodities, both domestically and from foreign sources. Speculative news also affects the commodity prices heavily, as socio-economic conditions deeply influence the productive capacity of respective companies.
The factors affecting commodity prices in an economy are discussed below –
- Market demand and supply
Market demand and consequent supply of goods traded on a commodity exchange heavily influence the market price. A rising demand (for any reason) can cause prices to rise in the short run, as supply cannot be increased immediately to compensate for the higher demand in the market. Generally, such a rise in demand can be attributed to a pessimistic performance outlook towards the stock market, thereby causing investors to shift towards relatively safer investment avenues.
- Global scenario
Global indicators play a crucial role in determining the prices of commodities available internally in a country. For example, any turmoil in the Middle Eastern countries can affect the prices at which crude oil is exported, thereby affecting the prices at which it is traded domestically.
A significant example can be cited in this respect when a supply shock was experienced by all major countries in the world triggered by Iraq-Kuwait tensions in the 1990s.
- External factors
Any condition affecting the total production of stipulated goods traded in an exchange can cause price changes accordingly. For example, a rise in the cost of production can drive up the prices at which a product is sold in the market, consequently affecting the equilibrium rate.
Also, the performance of the stock and bond market has an effect on the prices of commodities, as a negative viewpoint regarding their performances tends to divert investors towards commodity market securities. Individuals often trade in commodity derivatives to compensate for stock market risks, or to safeguard their portfolio from stock market downturns.
- Speculative demand
Demand for derivative investing in commodities online can arise from speculative investors, who aim to realise profits through market price fluctuations. Speculators often make predictions regarding the direction of movement of prices and aim to close the contract before the expiration date to realise capital gains on total gains.
Individuals unwilling to take physical delivery of the goods can opt for cash settlement contracts, whereby upon completion of the tenure of the futures contract, the difference between the price in spot trading and price stated in the futures contract has to be paid.
Depending upon the market assumptions, individuals can assume either a short or a long position in a futures contract. Investors expecting the price to drop in the future can undertake a short position (sell the security at a fixed price on a stipulated date) to realise profits through a fall in the market price. On the other hand, if individuals expect the price of a commodity future contract to rise in the future, they can opt to go long (buy the security at a fixed price on a stipulated date) so as to sell the same at higher prices in the future.
Nonetheless, a futures contract tends to merge with the spot price at which a commodity is trading at a future date, as prices adjust automatically at the expected level.
- Market outlook
Any unforeseen fluctuations in the stock market can cause investors to shift towards commodity trade, as chances of severe fluctuations in prices of certain commodities such as precious metals are low. Hence, commodity market investments are secure in nature and act as a hedge against inflation for risk-averse individuals.
Why Invest in the Commodities Market?
The importance of commodity markets investing is elucidated by the following factors :-
Commodities market demonstrate an inverse performance when compared to stock and bond market returns, as during a rise in the market prices of goods, stock and bond market returns falter. Investing a stipulated percentage of the investment corpus into the commodities market can help individuals reap high return on investment (ROI) even during a stock market downturn, helping them compensate for lower or negative profits generated by the capital sector.
- Inflation hedge
The prices of top commodities such as gold tend to rise over time, at a faster rate when compared to rising inflation rates in a country, allowing investors to enjoy a rise in the real value of their corpus investment. Also, as the demand for certain goods tends to rise or remain stable over time (such as gold, crude oil, etc.) the price graph of the same reflects a linear growth in the long run, wiping off any unsystematic fluctuations. Such technical analysis tools prove these commodities to be a profitable tool for individuals having a long term investment outlook.
- Margin trading
Commodity brokers offer a lower margin for trading relative to stock and bond market dealings. Essentially, it permits trading on borrowed funds (subject to SEBI regulations), allowing both hedgers and speculators to profit from the transaction. While commodity traders partaking physical delivery can benefit from bulk orders with a promise of repayment at a later date, speculators earn higher returns through such investments.
- Substantial returns
While certain goods are known for their stability, many commodities are subject to immense volatility as per the economic and capital market conditions. A prime example of volatile good is crude oil, whose price varies due to fluctuations in supply, arising from mining problems, or due to socio-economic conditions.
Speculators invest in commodities to profit from such price volatility and can attain a long or short position as per their market prediction, respectively.
- High risk –
The commodity market is volatile, as any fluctuations in the productive capacity, demand, or changing social circumstances readily affect the prices. Due to such high volatility, predicting the movement of commodity prices might be challenging, causing investors to lose out substantial returns due to unforeseen market events.
Hence, individuals need to be well-equipped with both the internal working of an economy as well as external factors such as international trade before choosing to trade in commodities. Additionally, the demand and supply patterns should be kept in mind to mitigate the risk further.
- Limited returns –
While stock and bond markets have periodic pay-outs such as dividend yields, coupon payments, etc. commodity investment can only generate capital gains.
While commodity market investments can reap significant returns, substantial expertise is required for the same. Nonetheless, individuals can trade in goods through any established commodity exchange by registering with a commodities broker.