BAJAJ BROKING
July 11, 2024
18 mins read
The commodity market is a place to trade goods and services and works on the principle of demand and supply. Here is everything an investor needs to know about the commodity market and how to begin their trading journey.
To grasp the significance of the commodity market in India, one must first understand what the commodity market is and why it holds importance:
The commodity market plays a major role in the world economy.
Understanding the workings of the commodity market contributes greatly to designing important policy frameworks.
Such frameworks help contribute towards the growth of society by
stabilizing the effects of inflation
alleviating poverty
enhancing food production
mitigating the potential effects of climate change
supporting a country’s sustainable growth goals
Before we delve deeper into the commodity market definition, it is important to understand what the commodity market is:
The main purpose of a commodity market is to open the doors for exchanging physical goods for a country’s citizens.
Here, investors can trade several commodities like spices, precious metals, crude oil etc in the same country.
Investors interested in diversifying their investment portfolio can undertake investments in perishable and non-perishable products.
The Forward Markets Commissions, which is the regulatory body for the commodity market and futures in India, recently enabled 120 commodities to perform future trading.
Two types of commodity market have been divided according to the inherent nature of the commodities being traded in them:
Hard Commodities
The hard commodities market is a typical commodity market example and it includes natural resources that require mining or extraction.
Some of the examples of hard commodities include metal ores, oil reserves, etc.
Hard commodities are a crucial part of establishing the economic health of a country.
In the commodity market, being able to monitor the demand for such hard commodities helps gauge the future trajectory of an economy.
When it comes to hard commodities, supply and demand are quite predictable as the commodities themselves have a fixed nature.
For example, gold becomes extremely valuable when the market slows down since investors can use it as a hedge against inflation.
Soft Commodities
Soft commodities include products that need to be grown or reared and taken care of.
Some of the examples of soft commodities include agricultural produce, livestock, etc.
When it comes to the value of soft commodities in the market, there is more volatility assigned to them.
This is mainly because their price-setting process is largely reliant on multiple external factors like environmental conditions.
This is why economies based on agriculture are more affected during a crisis like climate change.
Many types of commodities are divided between the hard and soft commodities market. These include:
Agriculture Commodities: Agriculture commodities include
Grains like rice, wheat, maize,
Oil and oilseeds like soy seeds, castor, refined soy oil, etc.
Spices like jeera, pepper, etc
Pulses or dals like chana, urad, etc
Metals and materials: Aluminium, copper, zinc, tin etc. are included here.
Bulk commodities: Hard commodities like iron ore, coking coal, bauxite, steel etc. come under this category.
Precious metals: Under this category, hard commodities like gold, silver, platinum, etc are included.
Energy: Crude oil, natural gas, Brent crude, thermal coal, alternate energy.
Apart from knowing what is commodity market, it is important to know that the commodity market is mainly dependent on the rule of demand and supply. Here are the four stages that encompass the working of the commodity market:
The Primary Production
For the commodity market to set up trades, the production of commodities is the primary stage.
Primary producers include cultivators, animal rearers, miners, etc.
These are the agents who bring commodities to the market to trade.
The Secondary Production Stage
In this stage, raw materials are converted to finished products.
Some examples include cotton into yarn or cloth, wheat into flour, or rice into rice powder.
The Distribution Stage
After the production stages, the trading stage comes to the fore.
In this stage, traders, wholesalers and retailers sell their finished goods in the commodity market.
With the help of the commodity market, this stage becomes very smooth and seamless for them.
The Consumption Stage
After the finished products are sold by the traders, wholesalers and retailers, this is the last stage of the commodity market.
In this stage, the fold finished goods and services are used by individuals and institutions.
These individuals and institutions can use these products for personal use or use in further processing or production.
In commodity derivatives trading, both Futures and Options trading are included.
Commodity Futures:
The Commodity Futures instrument is a contract that enables the buying and selling of a commodity at a pre-determined time and price in the future.
Commodity Futures can be traded on the stock exchanges by retail investors, corporates, and hedgers.
Commodity Options:
Commodity options, like the nature of every option, are classified as calls and puts.
In a call option, a buyer is given the right but is not obligated to buy a particular quantity of an underlying asset at a pre-determined price before its expiry.
Commodity puts let traders sell a particular number of underlying assets, without the obligation to do so, at a fixed price before it expires.
There are many benefits of investing in commodities. This holds for both the hard commodities market and the soft commodities market. Some of the benefits are listed below:
Portfolio Diversification
When compared to stocks and bonds the commodity market does better during a rise in the market prices of goods.
Investing a percentage of one’s funds into the commodities market can help investors get better ROI even when the stock market is down, possibly offsetting potential losses from the latter.
A Hedge Against Inflation
Prices of commodities like gold usually rise faster over time even with the growing inflation.
This price graph supports linear growth in the long run, again offsetting any unexpected fluctuations.
Commodities are a great investment for investors looking for long-term returns.
Supports Margin Trading
Commodity brokers provide a lower margin to investors.
This helps trade on borrowed funds thus helping hedge investors in particular profit through the transactions.
Significant Returns
While hard commodities are more stable, soft commodities are subject to immense volatility, dependent on the eternal conditions.
If done right, traders can earn significant returns from these very volatile fluctuations.
While trading in the commodity market offers several advantages, there are also notable drawbacks that investors should consider:
High Volatility: The commodity market is subject to rapid price fluctuations due to changes in supply and demand, geopolitical tensions, and natural disasters. This volatility can lead to significant financial losses. In addition to market volatility, sudden external events like geopolitical tensions can cause drastic shifts in the commodity market. The high-risk nature of the commodity market requires traders to stay vigilant in order to mitigate sudden losses.
Market Complexity: The commodity market is notably complex due to its global nature. Understanding the intricacies of the commodity market requires deep knowledge of both global and local economic factors. While traders who grasp the complexities of the commodity market can navigate volatile conditions more effectively and reduce financial risks, these same complexities can be overwhelming for new investors. Additionally, the evolving nature of technology, especially in trading platforms and data analytics, adds further layers of complexity to the commodity market, enabling more sophisticated strategies but requiring continuous adaptation.
Limited Returns: Unlike stocks and bonds, commodities primarily generate capital gains without periodic payouts. This can make it harder for investors to achieve steady income from their investments. Moreover, the commodity market primarily generates capital gains, which can be less predictable compared to other asset classes.
Regulatory Risks: Regulatory Risks: The commodity market operates under regulations that may affect trading practices and investor profits. Staying updated on the legal environment of the commodity market allows investors to anticipate changes and adjust strategies. Regulatory changes can introduce uncertainty for traders.
Dependency on External Factors: Especially in a global commodity market, prices can be heavily influenced by external factors, such as climatic conditions, which can make predictions challenging. This dependency on unpredictable events can increase risk.
High Transaction Costs: Trading commodities can involve significant transaction fees, especially in the commodity market where the complexity of trading adds additional layers of cost. This includes brokerage fees and costs associated with storage and transportation of physical goods. These costs can eat into profits.
Psychological Pressure: The high-stakes nature of trading in the commodity market can induce stress and lead to impulsive decision-making, which may negatively affect investment outcomes.
Leverage Risks: While leverage can amplify profits, it can also exacerbate losses. Investors using borrowed funds can find themselves facing substantial debts if trades do not go as planned. This is particularly true in the commodity market, where price movements can be unpredictable.
Investing in the commodity market can be lucrative, offering opportunities to hedge against inflation and diversify portfolios. However, the commodity market is constantly influenced by external factors, meaning that traders must stay updated. Potential investors in the commodity market must weigh these cons against the benefits and ensure they are well-informed about the risks involved. The commodity market also requires careful risk management strategies to successfully navigate its complexities. By understanding both the types of commodities and the workings of the commodities exchange, investors can make more strategic decisions aligned with their financial goals.
Here is a step-by-step guide to starting commodity trading:
The Commodity Broker
Choosing the right commodity broker is very important.
There are two types of brokers under commodity trading - full-service brokers and discount brokers.
Full-service brokers have physical branches across the country and thus charge higher fees.
Discount brokers mainly operate virtually and this is why they have nominal charges.
When choosing a broker, investors need to look at all the costs involved.
Open a Demat and Trading Account
Without a Demat and trading account, one can't start trading online in the commodity market.
To open a Demat and trading account documents like your PAN card, Aadhar card, age proof, income proof, and bank account statement are needed.
With the right broker, investors can easily open these accounts virtually.
Before approving the demat and trading account every detail put down by the investor will be checked.
Knowing an investor’s income status is crucial for the broker to minimise risks.
The Initial Deposit
When all the demat and trading account formalities are completed, the broker will send the investor the account details.
The investor needs to make an initial deposit in the account.
This amount should ideally be 10% of the contract value of the commodity that investors want to trade.
Investors also need to remember to add funds that constitute the maintenance margin.
Traders in the commodity market can be categorized into various types, each with distinct roles, objectives, and strategies that significantly impact market dynamics. Understanding these categories is crucial for navigating the complexities of the commodity market, which includes a wide range of raw materials and primary products. From energy resources like crude oil to agricultural goods such as wheat and coffee, the types of commodities traded influence economic conditions and investor strategies. By recognizing the different types of traders, investors can better tailor their approaches, manage risks, and seize opportunities in a market marked by both stability and volatility. Understanding the different types of commodities traded is also essential for developing effective investment strategies.
Hedgers:
Objective: Protect against price fluctuations and reduce risk.
Strategy: Enter into futures contracts to lock in prices for commodities they produce or consume.
Characteristics: These participants include farmers, manufacturers, and other producers who aim to stabilize their profit margins and manage risks associated with price volatility.
Speculators:
Objective: Seek profit from market fluctuations without intending to take physical delivery of commodities.
Strategy: They often utilize leverage to maximize potential returns, making trades based on market trends and predictions.
Characteristics: Speculators can be individuals or institutions, and their presence in the commodity market significantly influences pricing.
Hedgers play a vital role in the commodity market, as they are primarily concerned with mitigating risk rather than making speculative profits. By using futures contracts, they can ensure that they secure a specific price for their commodities, which is essential for producers like farmers who are subject to market fluctuations. For example, a wheat farmer might lock in a price for their harvest months in advance, allowing for better financial planning and stability.
Furthermore, hedging helps to maintain steady prices for consumers as well. For instance, if manufacturers know they can purchase their raw materials at a set price, they can manage their production costs effectively. Overall, hedgers contribute to market stability, making the commodities exchange a safer environment for all participants.
Speculators, on the other hand, thrive on the fluctuations within the commodity market. Their goal is to capitalize on price movements, which often means taking higher risks in pursuit of significant rewards. Unlike hedgers, speculators do not have a direct interest in the commodities themselves; rather, they focus on predicting market trends to maximize profits.
In the fast-paced world of commodity trading, speculators use a variety of strategies, including technical analysis and market sentiment evaluations, to inform their trading decisions. Their actions can create liquidity in the market, allowing for more efficient price discovery. However, the speculative nature of their trading can also lead to increased volatility, making the commodity market a dynamic space influenced by both hedging and speculative activities.
The principle of supply and demand is a fundamental factor in determining prices in the commodity market. For new traders, understanding what is commodity market involves learning the basic principles that drive commodity prices. Knowing what is commodity market also requires an understanding of external factors like geopolitical tensions and weather, which often impact supply and demand. When learning what is commodity market, it is crucial to understand how supply and demand interact. If demand for a commodity rises while supply remains constant, prices tend to increase. Conversely, if supply exceeds demand, prices typically fall. For instance, during a drought, the supply of agricultural commodities may decline, causing prices to rise due to increased demand for limited resources.
Additionally, the types of commodities traded can affect demand and supply dynamics. For example, energy commodities like crude oil may experience significant price fluctuations due to geopolitical events impacting supply chains. Understanding these interactions is crucial for traders navigating the complexities of the commodities exchange. The commodity market provides opportunities for investors to diversify their portfolios. By leveraging opportunities within the commodities exchange, investors can capitalize on market trends and manage risk more effectively.
Speculative demand plays a critical role in price determination within the commodity market. Speculators, who aim to profit from price fluctuations, influence market prices through their trading activities. When speculators anticipate an increase in prices, they may buy large quantities of a commodity, driving prices up. Conversely, if they predict a decline, they might sell off their holdings, causing prices to drop.
This speculative behavior can introduce volatility in the market, as traders react to news, trends, and economic indicators. It's essential for investors to monitor speculative demand, as it can significantly impact short-term price movements and overall market sentiment. Understanding the balance between speculative and fundamental demand is key to successful trading in the commodities exchange.
Various external factors can influence commodity prices significantly. These include economic indicators, geopolitical tensions, weather conditions, and changes in government policies. For example, an increase in interest rates can lead to a stronger currency, impacting the price of commodities traded internationally. Similarly, political instability in oil-producing regions can cause supply disruptions, resulting in price spikes in energy commodities.
Additionally, natural disasters such as hurricanes can disrupt agricultural production, leading to reduced supply and increased prices for affected commodities. Traders must remain vigilant about these external factors, as they can create sudden shifts in market conditions and affect the overall trading landscape in the commodity market.
The market outlook for commodities can shift based on various factors, including economic growth, inflation rates, and consumer behavior. A strong economy often correlates with increased demand for commodities, which leads to greater investments in the commodity market and drives prices higher. Conversely, during economic downturns, demand may wane, leading to price reductions.
Additionally, advancements in technology and shifts towards sustainability can also reshape the demand for certain commodities, affecting their long-term pricing trends. Furthermore, emerging trends such as sustainability and renewable energy can impact future demand for certain commodities, like fossil fuels versus renewable energy sources. Staying informed about market outlooks helps traders anticipate potential price movements and adjust their strategies accordingly, ensuring they remain competitive in the commodities exchange.
The global scenario plays a significant role in determining prices in the commodity market. International trade agreements, tariffs, and global supply chain dynamics can affect the availability and cost of commodities. In today's interconnected world, shifts in geopolitical relations or trade agreements can significantly impact the commodity market, influencing prices worldwide. Understanding the different types of commodities affected by these events helps investors adjust their strategies. For example, a trade war between major economies can lead to higher tariffs on agricultural products, impacting prices both domestically and internationally.
Moreover, global events, such as pandemics or economic crises, can cause widespread disruptions in production and distribution, leading to volatile price swings across various commodities. Traders must keep a close watch on the global scenario, as it can greatly influence the types of commodities available and their corresponding market prices.
Hedge Against Inflation: The commodity market serves as a strong hedge against inflation, especially for those investing in types of commodities such as precious metals and crude oil. As inflation increases, the prices of these commodities tend to rise, protecting the real value of your investments. Investors in commodities like gold or oil often see a steady appreciation of their assets even during periods of economic instability.
Diversification: Investing in the commodities exchange helps diversify portfolios, allowing investors to balance the risks associated with other asset classes like stocks and bonds. Commodities often perform inversely to traditional financial markets, providing a safety net during market volatility. This diversification is particularly useful when markets are facing downturns, ensuring your portfolio remains stable.
Profit From Market Fluctuations: The commodity market provides opportunities to profit from price fluctuations through futures and options trading. Investors can engage in these derivative contracts without needing physical possession of the commodities, making the market accessible and convenient. By accurately predicting market movements, speculators can make significant returns from the volatility in commodity prices.
High Liquidity: The commodities exchange is renowned for its high liquidity, allowing investors to quickly buy or sell assets. Additionally, the commodities exchange provides a transparent trading environment, ensuring fair pricing for both buyers and sellers. This ease of trade enables investors to react swiftly to market changes, whether they aim to capitalize on short-term trends or secure long-term positions. The commodities exchange plays a key role in facilitating these transactions by offering a centralized platform for buyers and sellers to engage in commodity trading. Commodities like gold, oil, and agricultural products are traded in high volumes, making it easy to enter or exit trades.
Global Market Access: Investors in the commodity market benefit from access to global markets. Whether it's crude oil from the Middle East or coffee from Latin America, commodities are traded worldwide. To succeed, traders must first understand what is commodity market and how global factors influence it. Knowing what is commodity market enables investors to make more informed decisions when trading globally. This global access broadens investment opportunities and helps investors hedge against local market risks. Additionally, global commodity markets provide stability by allowing diversification across regions, reducing the impact of localized economic downturns..
One of the key advantages of investing in the commodity market is diversification. Commodities often have an inverse relationship with stocks and bonds, meaning when traditional markets experience downturns, commodity prices may rise. This characteristic allows investors to balance the risks in their portfolios, ensuring that poor performance in one sector does not heavily impact their overall wealth.
By adding a range of types of commodities to an investment portfolio, such as metals, energy, and agricultural products, investors can mitigate risks. Commodities act as a safeguard within the context of a diversified commodity market, particularly during periods of economic instability, offering protection from potential losses in other financial markets.
The commodity market can deliver substantial returns when market conditions are favorable. Commodities like oil and natural gas often experience price fluctuations based on geopolitical events or changes in supply and demand. Investors who correctly predict these movements can realize significant profits, especially through derivatives such as futures contracts.
Additionally, commodities like gold provide a safe haven during times of economic uncertainty. This stability makes the commodity market attractive for both long-term and short-term investors, who can profit from its volatile nature.
Another advantage of the commodity market is the ability to engage in margin trading. This allows investors to trade large quantities of commodities with only a fraction of the required capital. By leveraging borrowed funds, traders can amplify their potential returns, especially in the commodity market where margin trading can be highly lucrative, making the market attractive to those willing to take on more risk.
However, margin trading also carries higher risk. Investors must be aware that while it can magnify profits, it can also lead to greater losses if market movements don’t align with their expectations. As such, it’s crucial for traders to closely monitor the market and manage their risks effectively.
Investing in the commodity market provides a natural inflation hedge. Commodities like gold, oil, and other essential raw materials typically increase in value as inflation rises. This is because the cost of production and goods naturally increases, pushing commodity prices up.
For investors, this means that as the purchasing power of currency decreases, their investments in commodities tend to rise in value. This makes commodities a reliable choice for those looking to preserve the value of their assets over time, especially in inflationary environments.
To understand what is commodity market it is important to understand its working and the benefits it provides a trader:
The classic commodity market definition would say that it is all about buying and selling raw materials and primary products.
Commodities are of two types; Soft and Hard Commodities.
Soft Commodities include agricultural goods and livestock.
Hard Commodities include commodities that can be extracted and mined which include metals, rubber, coins, and oil.
Of the most popular commodities, energy, wheat, gold, and coffee are some.
The commodity market runs on the principle of demand and supply.
Investors need to be aware of all the aspects of the commodity market to make profitable investments and steer clear of potential losses.
Disclaimer: Investments in the securities market are subject to market risk, read all related documents carefully before investing.
This content is for educational purposes only. Securities quoted are exemplary and not recommendatory.
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A question like what is commodity market might plague new investors but it is important to know that the main purpose of a commodity market is to open the doors for exchanging physical goods for a country’s citizens. Here, investors can trade several commodities like spices, precious metals, crude oil etc in the same country.
There are two different types of commodity market: Hard Commodities which Include natural resources that require mining or extraction and Soft Commodities which include products that need to be grown or reared and taken care of.
The commodity market works on the principle of demand and supply
In a spot market, spot commodities and other assets like currencies get traded for immediate delivery for cash. In a futures market, investors can choose to purchase a commodity at a later date.
The commodity market is mainly for individual retail traders and commercial entities
Some of the risks associated with commodity market trading include:
Price volatility of soft commodities
Leverage trading where higher returns exist but so do higher losses
Limited liquidity of the commodities because of trading at limited quantities
Commodity trading involves buying, selling, or exchanging raw materials like metals, oil, or agricultural products within a commodity market. This can be done through physical trades or derivative contracts in a commodities exchange, which includes various types of commodities such as hard and soft commodities.
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