How to Trade in Commodity Futures?

While commodity futures may appear to be a modern concept, their roots in India extend far into the past. As early as 1875, there existed a cotton futures exchange. However, futures trading in essential commodities ceased in the 1960s due to concerns about speculative practices and hoarding. It wasn't until 2002 that futures in commodities made a comeback in India.

Read on to learn more about how to trade in commodity futures.

What are Commodity Futures?

So, what do these futures entail? Let's begin by grasping the concept of futures contracts, which are derivatives whose value is contingent on an underlying asset. A futures contract empowers a buyer or seller to trade a commodity at a predetermined price in the future. Commodity futures cover a range of products, including cotton, wheat, petroleum, silver, gold, natural gas, etc.

For instance, consider a wheat farmer expecting a harvest of 100 quintals, intending to sell the produce at Rs 2,000 per quintal. Due to ongoing fluctuations in wheat prices, the farmer is uncertain about achieving the desired amount. To guard against these price swings, the farmer enters into a futures contract to sell 100 quintals at Rs 2,000 per quintal at the harvest time, set a month later. Subsequently, if wheat prices drop to Rs 1,500 per quintal, the farmer can exercise the futures contract, securing Rs 2,000 per quintal and gaining Rs 50,000.

However, there's a downside: if wheat prices rise to Rs 2,500, the farmer cannot capitalise on the price increase and must sell at the agreed-upon Rs 2,000, resulting in a potential loss of Rs 50,000. Nevertheless, producers prioritise assured prices over risky windfall profits, making commodity futures a valuable tool for them.

Beyond producers, end-users, and traders, speculators also benefit from price fluctuations, capitalising on market movements even without a direct interest in the commodity. Countries, too, engage in trading such futures, exemplified by significant petroleum importers. The economies of these nations are impacted by price changes, prompting them to enter into petroleum futures contracts to mitigate price risk to some extent.

A Three-Step Guide to Trade in The Commodity Market

Here is a systematic guide to engaging in online trading futures in commodities:

Pick a Commodity Broker

In the past, commodity trading proved to be quite intricate, deterring retail investors from venturing into the commodity market. However, thanks to the efforts of the Securities and Exchange Board of India (SEBI), investors can now easily participate in online commodity trading without complications.

Brokers in this domain fall into two primary categories: full-service brokers and discount brokers. Full-service brokers maintain numerous physical branches across the country, often incurring higher fees due to elevated establishment costs. On the other hand, discount brokers operate primarily online, adopting a streamlined model that generally translates to lower fees and potentially increased benefits.

Both full-service and discount brokers may provide commodity recommendations, free or paid, as well as benefits like free trades, low brokerage, and complimentary account opening. It is advisable to thoroughly assess the costs and services offered by different brokers before making a selection. Additionally, reading reviews about the broker is a prudent step to ensure a well-informed decision.

Open a Demat and Trading Account

Once you've settled on a broker, the next step involves opening a Demat and Trading account, both of which are imperative for engaging in commodity market transactions.

To initiate the process of opening a Demat and trading account, you'll need to provide essential documents such as your PAN card, Aadhar card, age proof, income proof, and bank account statement. Many brokers facilitate the online submission of these documents, and upon verification, they send the account details to your registered email address within one business day. It's important to note that your application will undergo a thorough examination to assess your eligibility.

Given that online trading futures in commodities often involves leverage, verifying the investor's income status is a crucial aspect for the broker to mitigate potential risks.

Once you have settled on a broker, the next step involves opening a Demat and Trading account, both of which are imperative for engaging in commodity market transactions.

Make The Initial Deposit

Upon receipt of the account details from the broker, the next step involves making an initial deposit. It is advisable to deposit approximately 10% of the contract value of the commodity you intend to trade, in addition to a maintenance margin.

For instance, if the margin requirement for trading a specific commodity amounts to INR 40,000, your deposit should be INR 4,000 along with the maintenance margin. The maintenance margin plays a crucial role in covering potential losses in case the market moves unfavourably against the anticipated direction.

Features of Commodity Trading

• The critical distinguishing aspect of commodities trading involves maintaining margin and adhering to a mark-to-market settlement system. Traders are required to uphold an initial margin, typically 5-10% of the contract value. Additionally, a maintenance margin might be imposed by the broker as a safeguard against unexpected adverse circumstances.
• Commodity market trades undergo a mark-to-market process. At the close of each trading day, the clearinghouse releases a settlement price for the commodity. The discrepancy between this settlement price and the contracted futures price is adjusted. Upon the trade's expiration, any differences in expectations between the contracting parties are settled.
• In comparison to other financial instruments, commodities have substantial lot sizes. The lot size, indicating the quantity of the commodity traded in a contract, is standardised and determined by the exchange.
• A commodity contract can be identified by a combination of the commodity's name and lot size. Lot sizes are further categorised into mini, micro, and standard based on the commodity quantity. For instance, the standard lot size for a gold contract on MCX is 1 kg, resulting in a high value per contract that demands a significant investment.
• The tenor of a commodity contract is predetermined, unlike stocks and other financial instruments, where decisions are made immediately. Consequently, investments in commodities tend to be of a short-term nature, with the contract concluding upon expiration.

How to Trade for Maximum Profits in Commodities?

Understand The Market Cycle

Commodities typically undergo cycles of ascension and decline, presenting opportunities for both upward and downward price movements. Regardless of the specific commodity, its price tends to exhibit frequent fluctuations, and adept traders leverage these oscillations to generate profits in the commodity market.

The majority of commodities adhere to a cyclical pattern. For instance, when there is a surge in demand for a particular commodity, the manufacturer's capital expenditure rises. This increase in capital expenditure prompts the company to raise the commodity's price.

Subsequently, as the commodity's price rises, consumer purchasing decreases, leading to a reduced demand for the commodity. As demand wanes, the company scales back its capital expenditure, resulting in a decline in the commodity's price. Investors must grasp the cyclical nature of the specific commodity they are trading and execute trades at reasonable price points.

Respect Volatility

For investors who are beginners and are entering the world of commodities for the first time, the inherent volatility and pronounced price fluctuations may induce apprehension. This is mainly when trading with significant leverage. Given that commodity brokers often offer leverage of up to 16 times, any incurred losses can rapidly escalate into substantial amounts.

Consequently, individuals new to commodity investment must acquaint themselves with the movement patterns and price ranges of commodities. A preliminary assessment of leading commodities indicates that agricultural commodities and metals, such as copper, tend to exhibit higher volatility compared to commodities like gold or crude oil.

For beginners, a prudent approach involves initiating trades in less volatile commodities before venturing into those with heightened volatility. This strategy allows for gradual acclimatisation to the intricacies of commodity trading and minimises the potential impact of wild price swings, especially when employing leverage.

Advantages of Commodity Futures Trading

• Price Discovery: Engaging in futures trading facilitates the process of price discovery, where prices are transparent, and liquidity ensures accurate market rates.
• Standardised: These regulated contracts make it easier to compare prices across global markets due to their standardised nature.
• Low Margin: Commodity trading involves lower margins compared to stocks and bond markets. Traders can leverage borrowed capital, increasing exposure to commodities. In cases of cash settlement, the settled differential price allows for higher returns.
• Hedging: Futures trading provides a mechanism for hedging against price fluctuations, reducing uncertainty for producers, traders, and end-users.
• Investor Benefits: Participating in futures trading offers investors the advantage of portfolio diversification. For instance, by leveraging gold futures, investors can hedge against the movement of other assets, protecting their portfolios.

Final Word

Trading in commodity futures presents various advantages. The potential for profitable outcomes is abundant, given the sustained demand for most commodities over the years. However, it's essential to acknowledge the associated high risks. Engaging in commodity trading is suitable for individuals with a substantial risk appetite, the ability to remain composed in tense situations, and the capacity to stay informed about international developments that may impact prices.

Typically, these futures markets are predominantly influenced by prominent market players possessing significant expertise. Nonetheless, there's no reason why retail investors cannot capitalise on these opportunities. Success in how to trade in commodity futures requires a degree of caution and the capability to assimilate a substantial amount of information swiftly.