What is Commodity Market: Basics of Commodity Market

If you thought that the equity market was the only financial market in the world, then you’re in for a surprise. There are a couple of other financial markets that are as popular as the stock market viz the currency market and the commodities market. Let’s delve a little deeper into the specifics of the commodities market and try to understand the basics.

Basic of commodities market

Similar to how the shares of a company are traded in the stock market, commodities are bought and sold in the commodities market. This financial market is widely utilized by producers, manufacturers, and wholesale traders as a price discovery mechanism for various goods and commodities.

Just like the stock market, there are dedicated commodity exchanges that enable the market participants to easily buy and sell commodities online. Three primary commodity exchanges are currently operational in India – the Multi Commodity Exchange (MCX), National Commodity and Derivatives Exchange (NCDEX),and Indian Commodity Exchange (ICEX).

Types of Commodities

Commodities are generally grouped into two categories: hard commodities and soft commodities. These categories help organise the various raw materials traded in global markets.

Hard Commodities

Hard commodities are natural resources that are mined or extracted from the ground. These include:

Precious Metals: Gold, platinum, and silver are desirable in relation to jewellery, funding, and in addition to commercial functions. These metals are usually safe-haven assets in times of economic uncertainty.
Industrial Metals: Copper, aluminium, and zinc are key to the construction business, electrical wiring, and manufacturing sectors.
Energy Resources: Crude oil, natural gas, and gasoline are crucial for powering industries, transportation, and households worldwide. They are significant drivers of global economic activity.

Soft Commodities

Soft commodities are usually livestock or agricultural products. These include:

Agricultural Products: Soybeans, wheat, rice, coffee, corn, and salt are vital food staples and ingredients in various industries. Their prices are very sensitive to weather conditions, geopolitical events, and demand worldwide.
Livestock: Live cattle, pork, and feeder cattle are important for the meat and dairy industries. They are affected by feed prices, disease outbreaks, and consumer preferences.

How Do you Invest in Commodities?

Investing in commodities requires a systematic approach to ensure informed decisions and minimise risks. Here are the steps to follow:

Understand Commodity Markets

Begin by familiarising yourself with the different types of commodities, such as metals, energy products, agricultural goods, and livestock. Research the factors influencing their prices, including global demand, supply constraints, geopolitical tensions, and seasonal patterns. This foundational knowledge helps identify potential investment opportunities.

Choose an Investment Method

Select the method that aligns with your financial goals and risk appetite. You can trade in commodity futures, which involve contracts to buy or sell commodities at a predetermined price on a future date.

For a more passive approach, consider investing in exchange-traded funds (ETFs) or mutual funds that track commodity performance. Alternatively, you can invest in the stocks of companies involved in commodity production, such as mining or oil firms. Physical ownership, such as buying gold or silver, is another option for tangible assets.

Select a Trading Platform

Choose a trusted brokerage platform or commodity exchange that is registered with regulatory authorities. Ensure it offers the commodities or investment instruments you are interested in.

Open an Account

Create a Demat and trading account with your chosen platform. This account is essential for trading in commodity markets, whether you’re dealing in futures, ETFs, or stocks.

Start Investing

Deposit funds into your trading account and use market analysis tools to identify the right time to buy or sell. Start small if you’re new to commodities, and gradually increase your exposure as you gain experience.

Monitor Your Investments

Keep a close eye on market conditions, commodity prices, and global developments. Regular monitoring ensures that you can make timely decisions and manage risks effectively.

How Commodity Markets Work

Commodity markets function by enabling the buying and selling of raw materials, either physically or through derivative contracts like futures and options. Prices are determined by supply-demand dynamics, geopolitical events, and economic trends. Investors trade on commodity exchanges, which provide a regulated platform to facilitate transactions, ensuring transparency, efficiency, and fair practices in the market.

How the Commodity Market Relates to the Stock and Bond Markets

The commodity market, stock market, and bond market are interconnected components of the financial ecosystem, each influencing and reflecting broader economic conditions.

Commodities and stocks are often linked through the performance of specific sectors. For example, companies in industries like mining, oil, and agriculture are directly impacted by commodity price fluctuations. Rising oil prices can boost the profits of energy companies, leading to increased stock prices, whereas higher raw material costs may reduce profitability for manufacturing firms.

The bond market and commodity market also share a relationship, primarily through inflation. Commodities like oil and gold are considered inflation-sensitive assets. Rising commodity prices can lead to higher inflation, reducing the real bond returns and impacting their demand and prices. Conversely, lower commodity prices may ease inflationary pressures, supporting bond values.

Furthermore, commodities often serve as a hedge against stock and bond market volatility. During periods of economic uncertainty, investors may turn to safe-haven commodities like gold, which indirectly impacts both markets.

Overall, the interplay among these markets reflects global economic conditions, investor sentiment, and risk preferences. Understanding these relationships can help investors diversify their portfolios and mitigate risks effectively.

Traders in a Commodity Market

Traders in a commodity market perform specific roles that contribute to its functionality and efficiency. Here are the main types of traders:

Hedgers: Hedgers are businesses or individuals who trade in the commodity market to protect themselves against price fluctuations. For instance, a farmer may hedge by locking in the price of crops before harvest, or an airline may secure stable fuel costs to avoid the impact of rising crude oil prices. Their goal is to minimise risk rather than earn profits.
Speculators: Speculators trade commodities to profit from short-term price movements. Unlike hedgers, they do not intend to take physical delivery of the commodity. Instead, they capitalise on market volatility, often taking high risks in pursuit of significant returns.
Arbitrageurs: Arbitrageurs exploit price differences between different markets or contracts for the same commodity. By buying in one market and selling in another, they earn risk-free profits. Their activities ensure price alignment and contribute to market efficiency.
Market Makers: Market makers provide liquidity to the commodity market by consistently offering to buy and sell commodities. They play a crucial role in maintaining efficient trading operations and ensuring that buyers and sellers can execute trades smoothly.
Investors: Investors focus on long-term gains by adding commodities to their portfolios. They invest through exchange-traded funds (ETFs), mutual funds, or physical assets like gold. Unlike speculators, investors are less concerned with short-term price movements and aim for diversification and inflation protection.

How Are Commodity Prices Determined on the Exchange?

In India, commodity prices on exchanges are shaped by a combination of domestic and global factors. Understanding these influences is essential for traders, producers, and investors.

Supply and Demand Dynamics

The primary driver of commodity prices in India is the balance between supply and demand. For instance, a bumper harvest of rice or wheat due to favourable monsoon conditions can lead to lower prices, while a poor harvest caused by drought or floods can result in price spikes. Domestic production levels and consumption trends play a critical role in shaping this balance.

Geopolitical and Global Events

Global events, such as conflicts or trade restrictions in major commodity-producing countries, impact prices in India. For example, disruptions in crude oil supply from the Middle East, a key supplier to India, can lead to a surge in domestic fuel prices. International decisions, such as those by OPEC, and global sanctions also affect Indian markets.

Seasonal Variations

In India, many agricultural commodities experience seasonal price trends. For instance, the prices of sugarcane, pulses, or vegetables like onions tend to fluctuate based on harvest periods. Pre-harvest shortages often drive prices higher, while post-harvest gluts lead to lower prices.

Currency Fluctuations

Since India imports significant commodities like crude oil and gold, the value of the Indian rupee against the US dollar has a direct impact on prices. A weaker rupee makes imports costlier, driving up domestic commodity prices, whereas a stronger rupee reduces import costs and lowers prices.

Market Speculation and Sentiment

Speculators on commodity exchanges, such as MCX and NCDEX, contribute to short-term price fluctuations. Their activities, driven by market sentiment and predictions of future trends, often create volatility. For instance, anticipated shortages of agricultural commodities can lead to speculative buying, raising prices even before actual shortages occur.

Production Costs

Production costs in India, including input costs like seeds, fertilisers, electricity, and labour, significantly influence commodity prices. An increase in fuel prices, for example, raises transportation and irrigation costs, which are then reflected in higher prices for agricultural produce.

Futures Contracts

In India, futures trading on exchanges like MCX and NCDEX influences spot prices. Futures contracts enable traders to hedge against future price changes, and the market’s expectations regarding supply and demand dynamics are factored into current pricing.

Government Policies and Interventions

Indian government policies, such as minimum support prices (MSP) for crops, export bans, or import duties, heavily impact commodity prices. For example, imposing export restrictions on onions or wheat during shortages helps stabilise domestic prices but reduces global supply.

Inventory Levels and Stockpiles

The stock levels of key commodities maintained by organisations like the Food Corporation of India (FCI) also affect prices. Higher inventories indicate surplus supply, often leading to stable or reduced prices, whereas lower reserves may trigger price hikes.

Economic Indicators and Industrial Demand

India’s economic performance directly affects commodity demand. Robust industrial growth increases the demand for metals like copper and aluminium, driving prices higher. Conversely, an economic slowdown can lead to reduced demand and lower prices.

Transportation and Logistics Costs

In India, high logistics costs due to inadequate infrastructure, rising diesel prices, or disruptions like roadblocks and port congestion can lead to higher commodity prices. Efficient transport systems and lower fuel costs are key to maintaining price stability.

Importance of Investing in the Commodities Market

Investing in the commodities market holds significant importance, especially in the Indian context. It offers diverse opportunities for investors and helps strengthen portfolios against market volatility. Here are the key reasons why investing in commodities is beneficial:

Portfolio Diversification: Investing in commodities provides a hedge against risks associated with equities and bonds. Commodities often show inverse performance to traditional asset classes, offering balance and reducing overall portfolio volatility.
Inflation Hedge: Commodities act as a safeguard against inflation. When inflation rises, the prices of commodities like gold, crude oil, and agricultural products typically increase, ensuring that investors maintain purchasing power during economic fluctuations.
High Liquidity: Commodity markets in India, such as the Multi Commodity Exchange (MCX) and National Commodity and Derivatives Exchange (NCDEX), are highly liquid. This enables traders to enter and exit positions swiftly, making it a flexible investment avenue.
Global Demand and Supply Dynamics: Indian investors can capitalise on global demand for commodities like crude oil, natural gas, and precious metals. As these markets are influenced by international trends, they offer an opportunity to benefit from global price movements.
Protection Against Currency Fluctuations: Since commodities are traded internationally and often priced in US dollars, they can provide a hedge against rupee depreciation. Investments in gold, for example, often increase in value when the rupee weakens.
Tangible Assets: Unlike stocks, commodities are physical assets, giving investors a sense of ownership. Gold, silver, and agricultural produce are tangible investments that hold intrinsic value.
Speculative Opportunities: The commodities market allows traders to speculate on price movements, creating opportunities for short-term profits. Futures and options trading further enhance profit potential.

Limitations of Trading in the Commodity Market

The commodity market presents a wealth of investment opportunities, but like any financial market, it comes with its own set of challenges. Traders must be aware of the risks and limitations involved to make informed decisions and manage their investments wisely. Below are some key limitations of trading in the commodity market:

High Volatility: Commodity prices are highly volatile due to factors like weather, geopolitical events, and supply-demand imbalances, making trading risky.
Lack of Knowledge: Many traders in India lack sufficient understanding of commodity markets, leading to uninformed decisions and potential losses.
Leverage Risks: Leverage amplifies both profits and losses, and improper use can result in significant financial setbacks.
Limited Market Access: In India, smaller towns and rural areas may have limited access to commodity trading platforms.
Storage and Transportation Costs: Physical commodity trading involves additional costs for storage and logistics, impacting overall returns

Conclusion

As with most online investments, your journey into the commodities market starts with the need to open a trading account with a brokerage firm. Once you have your trading account set up and ready by using a stock market app, you can start investing in the various commodities of your choice through derivative contracts such as futures and options.

When you purchase commodity derivative contracts and hold them till expiry, the contracts are mandatorily settled through physical delivery. Therefore, if you don’t wish to take delivery of the commodities that you’ve invested in, ensure that you close all your open positions well ahead of the contract expiry.

Commodity Market: Basics, Types, & Importance