How to Start Trading in Commodities

How do you invest in commodities? Can you invest in commodities in commodities in the first place? That is a question we will explore here while also looking at how to start trading commodities. The process of how to start commodity trading is not too tough since it is almost like equity trading and even the screens are almost like that. The only thing you need to know about how to invest in commodities is whether you want to speculate on the price movement or hedge using an underlying position. We will also look in detail at how to start trading commodities in India.

What are how you can invest in commodities? Frankly, there are many ways. You can invest in commodities by taking a speculative position in commodity futures. You can invest in commodities by taking a speculative position in commodity options. You can also invest in commodities using hedging by taking delivery of the underlying commodity. You can invest in commodities across the spectrum and these include precious metals, oil & natural gas, industrial metals, and agricultural commodities.

How to Start Trading in Commodities or How to Invest in Commodities?

That is where your commodity trading service offered by brokers comes in handy. Today, most brokers offer commodity trading and it is possible to trade and also invest in commodities online using the internet interface. Commodity trading also provides diversification from your core exposure to equities and bonds, since they normally tend to be negatively correlated.

Commodity trading, in terms of popularity, is yet to become as big as equity or F&O trading. In a way, the commodity transaction tax or CTT has been a dampener on volumes. However, traders are increasingly becoming aware of the advantages of commodity trading and are also willing to try out this new product for play speculation and also for hedging risk.

The first step to start trading commodities, like in equity trading is to do the basic KYC and open your commodity trading account. As of now, the commodity trading account still has to be distinct from your equity trading account. Just as you need a demat account for equity trading, you also need a demat account for trading in commodities. Demat account functions like a bank account except that in this case, your holdings are the commodity futures or options position in the market. The demat account stores the information of your trades as well as the actual holdings of the instruments that you have invested in.

Currently, traders in commodities are permitted to open a demat account with NSDL. Broadly, there are 4 types of commodity contract commodities that are traded on the two major commodity exchanges viz. MCX and NCDEX.

1. Precious Metals: This includes gold and silver and the denominations and lot sizes in terms of KG/grams are defined by the exchange. MCX has a dominant position in trading in precious metals.
2. Industrial or base metals: This includes trading in copper, zinc, aluminum, etc which are basic industrial inputs used for manufacturing a variety of products. Even in base metals, the MCX has a leadership position.
3. Hydrocarbon contracts: This includes crude oil and natural gas. Crude oil on the MCX is benchmarked to the WTI crude traded on the NYMEX and the settlement price is taken from WTI, which is the global benchmark delivery price. MCX has a leadership position in oil and natural gas trading too.
4. Agricultural commodities: These include a host of Agri products like Mentha, Mentha oil, guar gum, pulses, etc. This is the one segment in which NCDEX has a much stronger leadership position compared to NCDEX.

Commodity Trading Strategies

Just as you have strategies in trading equities or futures and options on equities and indices, you also have strategies in commodities. Here are some of the popular strategies although the spread is not as wide as equity F&O due to the limited volumes.

Using moving averages and breakouts to do technical trading in commodities is one of the most popular strategies. When it comes to commodities, they normally go through a long supercycle. Within these cycles, the commodity prices tend to follow certain underlying trends that can be tracked with moving averages and by the price line cutting or below the moving average line. One more way to use the technical charts is by identifying breakouts. These breakouts are direction changes that are confirmed by the volume support and can be a useful guide to big returns.

• The commodity markets in India offer futures and options and hence traders can use basic strategies or combinations. For example, they can use protective puts to hedge their long positions in commodities. Similarly, they can reduce the cost of holding long positions by using covered calls. These are some of the basic uses of options.
• A low-risk approach to trading commodities is by trading spreads. Spreads are common in equities, indices, currencies, and even commodities. In a spread, you are normally long/short. For example, gold and copper may move contrary to each other. If you are positive on copper, you do a pair trade. Also, you can do a spread between the current month and next month, which is called a calendar spread.
• The last strategy is to stick to your comfort zone. Most traders have specialization in one or two commodities and it is best to specialize and just stick to trading in that commodity or the small set of commodities, which is familiar ground.

Advantages of Commodity Trading

Does commodity trading offer any unique advantages? It offers several advantages. Here is a quick summation. Let us look at four such advantages that trading in commodities offers you.

• Today every commodity from copper to steel to zinc is seeing a sharp surge in prices. How to protect against such a situation. The simple method is to buy futures in these commodities by paying a margin or by buying call options on such contracts. That way, any rise in inflation is offset by the profits on your long commodity position.
• The real edge of commodity trading is that it gives protection to those with exposure. For example, an electric car manufacturer needs large amounts of copper and hence needs assurance that copper prices do not go out of hand. Buy copper futures for delivery in advance, such EV manufacturers can lock in the price of copper. That gives them greater certainty in the cost of production and also in planning.
• Commodity trading is not just done by hedgers but also by speculators. One reason speculators love commodity futures is the huge leverage that it offers. Normally, commodity margins are 5-7% of the price. That means, your leverage is 14 to 20 times the margin you put in. That is music to the ears of traders and speculators. However, a word of caution is that it comes with its own set of risks.
• Commodities, especially commodities like gold, tend to have a low correlation with equities. Hence, if you want to diversify your concentration inequities and don’t want to invest to buy gold, you can replicate the trade by purchasing gold futures. That will give you the same pay-offs as actually holding gold.