Picture credits: Holborn Assets
What is a commodity you ask? Investopedia defines commodity as a “basic good used in commerce that is interchangeable with other commodities of the same type.” Think of commodities as raw materials used in the synthesis of products and services. Although its quality may slightly differ from producer to producer, the difference is almost negligible. For example, a barrel of oil is the same product, regardless of who’s manufactured it. Commodities also include financial products such as foreign currencies and indices.
Commodity Buyers and Producers
Buying and selling of commodities are usually done through futures contracts on exchanges which set standards for the quality as well as the number of commodities being traded. There are 2 types of commodity traders. One is buyers and producers that use futures contracts for hedging purposes. They make or take the delivery of the commodity when the contract expires. Example, the wheat farmer who plants a crop is able to hedge against the risk of loss of money if its price falls before the crop is harvested.
Types of Commodities
Commodities are divided into 4 main types:
1. Agricultural: Agricultural commodities include food crops (corn, wheat, etc.), livestock (pork, beef, etc.) and cash crops (wool, cotton, etc.).
2. Energy: This category includes sources of energy such as crude oil, coal, electricity.
3. Metals: Precious metals of very high value such as gold, silver, etc. and base metals such as steel iron ore, etc.
4. Environmental: Carbon emissions, white certificates, etc.
Factors responsible for commodity price movements
Although each commodity is unique in terms of factors affecting its price movements, there are certain factors the are common among most commodities:
1. Emerging Market Demand: With growing economies comes a growing need for raw materials such as crops and livestock to feed people, metals for infrastructure and energy to run cities. Demand from new emerging markets as well as countries’ economies affects prices.
2. Supplies: The scarcity of abundance of commodities could also affect the price movements. Once such number is the size of the annual crop. Other factors include political, economic and labor issues. Inventory levels are said to have a significant impact on price movements as well. If consumers build up inventory levels it may increase supply and reduce prices. Conversely, a dip in inventory levels could skyrocket prices.
3. US Dollar: When the value of the dollar against other currencies drops, it would take more amount of dollars to buy commodities than it would when the price was higher. In a nutshell, commodity sellers get lesser dollars when dollar rates are high and vice-versa.
4. Substitution: The principles of substitution apply to commodities as well. When prices for a certain commodity surge, buyers will automatically resort to cheaper alternatives. Eg. Aluminum is used as a cheaper alternative for copper in certain industries. When it comes to crops, farmers may shuffle between corn, oats, and wheat based on their prices.
5. Weather: Weather conditions such as drought or excessive rainfall can affect the yields (supply) of crops causing prices to fluctuate. For example, in the energy sector, hurricanes, storms or cold weather can hamper drilling as well as refining activity leading to reduced supply and hence an increase in price.
Trading commodities online
Commodities are the fourth biggest investment vehicles when it comes to trading in India after equity, real estate and precious metals like gold and silver.
Even though trading commodities may have its own risks and challenges, you also have the opportunity of making good profits buying and selling commodities online which comes with experience and dedication.
As a trader, you must be aware of the different types of commodities, the different world markets and stay in touch with the economic changes that are responsible for price fluctuations in commodities. Here are some of the steps to follow to start with commodities trading basics:
1. Knowledge about Commodity Trading Exchanges
The first step should be knowing what exchanges facilitate trading of commodities. In India, commodities trading is done on the National Commodity and Derivative Exchange (NCDEX), National Multi Commodity Exchange (NMCE) and the Multi Commodity Exchange (MCX).
2. Choosing your broker
It’s important to choose a suitable and efficient stock broker companies. The broker should be registered and regulated. Choosing your broker is of utmost importance because the stockbrokers are the people who are responsible for holding your account and doing trades.
The brokers also keep traders posted about trends and news that can affect commodity prices in the form of tips as well as making sound buying and selling decisions.
Another important thing to take into consideration is the fee (or brokerage) that is charged by the broker for their services. Some of the fees include:
· Platform fee
· Clearing fee
Another factor to consider while choosing a broker is the kind of services the brokerage provides on its platform. Some of the requisites that should be satisfied are charts, historical market data, etc.
3. Opening your commodity trading accounts
Well, now that you’ve hopefully picked the right broker for you, you will have to open a demat account. You can open a demat account by going to your bank and filling up an application with your broker along with information related to age, income, etc.
The broker analyses the information and approves or rejects the opening of the account based on certain metrics such as risk-appetite, credit rating and experience in trading. This process is important as the broker needs to make sure that the trader is capable of paying his debt in case the market plunges leading to a loss. Once the application is approved, the account is good to go.
4. Making your initial deposit
The trader has to make an initial deposit to begin trading. It usually equates to about 5 to 10% of the contract value. Eg. In the case of gold, the initial margin money is Rs. 3200 which is more or less 10% of one trading unit of gold (10gms).
5. Creating a trading plan
The trading plan must be based on a deep understanding of the market, practicing using market simulations and understanding the trader’s personal style, amount of capital at his disposal and risk appetite.
Trading plans will differ from trader to trader. The broking company provides the trader with fundamental and technical analysis tools and metrics.
An investor must be well-prepared and well-aware. A trader should know about risk management strategies and not over trade in order to prevent loss of money. It takes a lot of hard work, dedication, and discipline to make money off of commodity trading.